With an ROE of 31.07%, Holly Energy Partners LP. (NYSE:HEP) outpaced its own industry which delivered a less exciting 10.21% over the past year. On the surface, this looks fantastic since we know that HEP has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable HEP’s ROE is. View our latest analysis for Holly Energy Partners
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Holly Energy Partners’s profit relative to its shareholders’ equity. An ROE of 31.07% implies $0.31 returned on every $1 invested. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Holly Energy Partners’s cost of equity is 9.76%. Since Holly Energy Partners’s return covers its cost in excess of 21.30%, its use of equity capital is efficient and likely to be sustainable. Simply put, Holly Energy Partners pays less for its capital than what it generates in return. ROE can be broken down into three different 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. Asset turnover reveals how much revenue can be generated from Holly Energy Partners’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt Holly Energy Partners currently has. Currently the debt-to-equity ratio stands at a high 246.83%, which means its above-average ROE is driven by significant debt levels.
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Holly Energy Partners exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Its high debt level means its strong ROE may be driven by debt funding which raises concerns over the sustainability of Holly Energy Partners’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For Holly Energy Partners, I’ve compiled three key factors you should further research:
- 1. 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.
- 2. Valuation: What is Holly Energy Partners 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 Holly Energy Partners is currently mispriced by the market.
- 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Holly Energy Partners? 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.