Will Hydrogen Group PLC (AIM:HYDG) Continue To Underperform Its Industry?
Hydrogen Group PLC (AIM:HYDG) generated a below-average return on equity of 0.01% in the past 12 months, while its industry returned 16.80%. HYDG’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on HYDG’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of HYDG’s returns. Check out our latest analysis for Hydrogen Group
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of HYDG’s profit relative to its shareholders’ equity. An ROE of 0.01% implies £0 returned on every £1 invested. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for HYDG, which is 8.30%. Since HYDG’s return does not cover its cost, with a difference of -8.29%, this means its current use of equity is not efficient and not sustainable. Very simply, HYDG pays more 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:
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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient HYDG is with its cost management. Asset turnover shows how much revenue HYDG can generate with its current asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable HYDG’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check HYDG’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a low 11.28%, which means HYDG still has headroom to take on more leverage in order to increase profits.
What this means for you:
Are you a shareholder? HYDG’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means HYDG still has room to improve shareholder returns by raising debt to fund new investments. 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 HYDG 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 Hydrogen Group 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.
