Norwest Energy NL’s (ASX:NWE) most recent return on equity was a substandard 9.09% relative to its industry performance of 15.19% over the past year. Though NWE’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on NWE’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of NWE’s returns. View our latest analysis for Norwest Energy

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

Return on Equity (ROE) is a measure of Norwest Energy’s profit relative to its shareholders’ equity. An ROE of 9.09% implies A$0.09 returned on every A$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 Norwest Energy’s equity capital deployed. Its cost of equity is 8.69%. While Norwest Energy’s peers may have higher ROE, it may also incur higher cost of equity. An undesirable and unsustainable practice would be if returns exceeded cost. However, this is not the case for Norwest Energy which is encouraging. 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

The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue Norwest Energy can generate with its current 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 ROE can be inflated by excessive debt, we need to examine Norwest Energy’s debt-to-equity level. Currently, Norwest Energy has no debt which means its returns are driven purely by equity capital. This could explain why Norwest Energy’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. While Norwest Energy exhibits a weak ROE against its peers, its returns are sufficient enough to cover its cost of equity. Also, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.