Northern Star Resources Limited (ASX:NST) outperformed the Gold industry on the basis of its ROE – producing a higher 35.41% relative to the peer average of 11.51% over the past 12 months. Superficially, this looks great since we know that NST has generated big profits with little equity capital; however, ROE doesn’t tell us how much NST has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of NST’s ROE. View our latest analysis for Northern Star Resources

Peeling the layers of ROE – trisecting a company’s profitability

Return on Equity (ROE) weighs NST’s profit against the level of its shareholders’ equity. For example, if NST invests $1 in the form of equity, it will generate $0.35 in earnings from this. 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 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 NST, which is 9.58%. Given a positive discrepancy of 25.83% between return and cost, this indicates that NST pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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

Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from NST’s 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 NST’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check NST’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a low 1.82%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.

What this means for you:

Are you a shareholder? NST’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis. 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 you are considering investing in NST, basing your decision on ROE alone is certainly not sufficient. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Northern Star Resources 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.