Z Energy Limited (NZSE:ZEL) outperformed the Oil and Gas Refining and Marketing industry on the basis of its ROE – producing a higher 35.31% relative to the peer average of 10.52% over the past 12 months. While the impressive ratio tells us that ZEL has made significant profits from little equity capital, ROE doesn’t tell us if ZEL has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable ZEL’s ROE is. Check out our latest analysis for Z Energy

What you must know about ROE

Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 35.31% implies NZ$0.35 returned on every NZ$1 invested. 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 Z Energy, which is 9.65%. This means Z Energy returns enough to cover its own cost of equity, with a buffer of 25.66%. This sustainable practice implies that the company pays less 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:

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 Z Energy’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine Z Energy’s debt-to-equity level. The debt-to-equity ratio currently stands at a balanced 140.82%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Z Energy exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. Although ROE can be a useful metric, it is only a small part of diligent research.

For Z Energy, there are three relevant aspects you should further examine:

1. 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.

2. Valuation: What is Z Energy 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 Z Energy is currently mispriced by the market.

3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Z Energy? 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 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.