This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning the link between HomeStreet Inc (NASDAQ:HMST)’s return fundamentals and stock market performance.
With an ROE of 9.39%, HomeStreet Inc (NASDAQ:HMST) outpaced its own industry which delivered a less exciting 5.71% over the past year. On the surface, this looks fantastic since we know that HMST 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 HMST’s ROE. See our latest analysis for HomeStreet
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs HomeStreet’s profit against the level of its shareholders’ equity. An ROE of 9.39% implies $0.094 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 HomeStreet’s equity capital deployed. Its cost of equity is 9.58%. Since HomeStreet’s return does not cover its cost, with a difference of -0.19%, this means its current use of equity is not efficient and not sustainable. Very simply, HomeStreet pays more for its capital than what it generates in return. ROE can be dissected into three distinct 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 HomeStreet can make from its 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 the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt HomeStreet currently has. Currently the debt-to-equity ratio stands at a balanced 143.44%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. HomeStreet exhibits a strong ROE against its peers, however it was not high enough to cover its own cost of equity this year. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For HomeStreet, I’ve compiled three key aspects you should further research:
- Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Valuation: What is HomeStreet worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether HomeStreet is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of HomeStreet? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!
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.