With an ROE of 19.06%, Hugoton Royalty Trust (NYSE:HGT) outpaced its own industry which delivered a less exciting 9.06% over the past year. While the impressive ratio tells us that HGT has made significant profits from little equity capital, ROE doesn’t tell us if HGT has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable HGT’s ROE is. Check out our latest analysis for Hugoton Royalty Trust
What you must know about ROE
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 19.06% implies $0.19 returned on every $1 invested. 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 Hugoton Royalty Trust’s equity capital deployed. Its cost of equity is 10.05%. Given a positive discrepancy of 9.01% between return and cost, this indicates that Hugoton Royalty Trust pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue Hugoton Royalty Trust can generate with its current asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Hugoton Royalty Trust currently has. Currently, Hugoton Royalty Trust has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.
What this means for you:
Are you a shareholder? HGT exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of HGT to your portfolio if your personal research is confirming what the ROE is telling you. 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 HGT 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 Hugoton Royalty Trust 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.