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Dominion Energy Inc (NYSE:D) outperformed the Multi-Utilities industry on the basis of its ROE – producing a higher 16.11% relative to the peer average of 9.47% over the past 12 months. While the impressive ratio tells us that D has made significant profits from little equity capital, ROE doesn’t tell us if D has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of D’s ROE. See our latest analysis for Dominion Energy
What you must know about ROE
Return on Equity (ROE) is a measure of Dominion Energy’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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. Dominion Energy’s cost of equity is 8.80%. Given a positive discrepancy of 7.31% between return and cost, this indicates that Dominion Energy 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
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 Dominion Energy’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 the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Dominion Energy currently has. The debt-to-equity ratio currently stands at a high 193.13%, meaning the above-average ratio is a result of 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. Dominion Energy’s ROE is impressive relative to the industry average and also covers 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 Dominion Energy’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.