Yahoo Finance Will Home Capital Group Inc (TSE:HCG) Continue To Underperform Its Industry?
I am writing today to help inform people who are new to the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Home Capital Group Inc’s (TSE:HCG) most recent return on equity was a substandard 6.65% relative to its industry performance of 7.92% over the past year. 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 HCG’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of HCG’s returns.
Check out our latest analysis for Home Capital Group
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Home Capital Group’s profit relative to its shareholders’ equity. An ROE of 6.65% implies CA$0.066 returned on every CA$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 measured against cost of equity in order to determine the efficiency of Home Capital Group’s equity capital deployed. Its cost of equity is 11.84%. Since Home Capital Group’s return does not cover its cost, with a difference of -5.20%, this means its current use of equity is not efficient and not sustainable. Very simply, Home Capital Group pays more 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:
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 Home Capital Group’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 financial leverage can artificially inflate ROE, we need to look at how much debt Home Capital Group currently has. The debt-to-equity ratio currently stands at a high 168.19%, meaning the below-average ratio is already being driven by a large amount of debt.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Home Capital Group’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Also, with debt capital in excess of equity, ROE may already be inflated by the use of debt funding, raising questions over the possibility of further decline in the company’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For Home Capital Group, 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 Home Capital Group 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 Home Capital Group is currently mispriced by the market.
Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Home Capital Group? 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 past 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. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.
