HomeServe plc (LSE:HSV) delivered an ROE of 21.67% over the past 12 months, which is an impressive feat relative to its industry average of 15.19% during the same period. On the surface, this looks fantastic since we know that HSV has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of HSV’s ROE. View our latest analysis for HomeServe
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs HSV’s profit against the level of its shareholders’ equity. It essentially shows how much HSV can generate in earnings given the amount of equity it has raised. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of HSV’s equity capital deployed. Its cost of equity is 8.30%. Since HSV’s return covers its cost in excess of 13.37%, its use of equity capital is efficient and likely to be sustainable. Simply put, HSV pays less for its capital than what it generates in return. ROE can be split up into three useful ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:
ROE = profit margin × asset turnover × financial leverage
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = annual net profit ÷ shareholders’ equity
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue HSV can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable HSV’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt HSV currently has. The debt-to-equity ratio currently stands at a sensible 83.14%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
What this means for you:
Are you a shareholder? HSV’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.
Are you a potential investor? If HSV has been on your watch list for a while, making an investment decision based on ROE alone is unwise. I recommend you do additional fundamental analysis by looking through our most recent infographic report on HomeServe to help you make a more informed investment decision.
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned.