Beazer Homes USA Inc (NYSE:BZH) delivered a less impressive 4.82% ROE over the past year, compared to the 11.23% return generated by its industry. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into BZH’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of BZH’s returns. View our latest analysis for Beazer Homes USA
Breaking down Return on Equity
Return on Equity (ROE) weighs Beazer Homes USA’s profit against the level of its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.05 in earnings from this. 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
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 Beazer Homes USA, which is 17.53%. This means Beazer Homes USA’s returns actually do not cover its own cost of equity, with a discrepancy of -12.71%. This isn’t sustainable as it implies, very simply, that the company 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:
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 the business is with its cost management. Asset turnover reveals how much revenue can be generated from Beazer Homes USA’s 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 ROE can be inflated by excessive debt, we need to examine Beazer Homes USA’s debt-to-equity level. At 194.51%, Beazer Homes USA’s debt-to-equity ratio appears relatively high and indicates the below-average ROE is already being generated by significant leverage levels.
What this means for you:
Are you a shareholder? BZH’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Additionally, with debt capital in excess of equity, the existing ROE is being generated by debt funding, which is something you should be aware of before buying more BZH shares. 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 BZH 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 Beazer Homes USA 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.