New Hope Corporation Limited (ASX:NHC) delivered a less impressive 7.59% ROE over the past year, compared to the 9.69% return generated by its industry. Though NHC’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 NHC’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of NHC’s returns. Check out our latest analysis for New Hope

Breaking down Return on Equity

Return on Equity (ROE) is a measure of New Hope’s profit relative to its shareholders’ equity. An ROE of 7.59% implies A$0.08 returned on every A$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 measured against cost of equity in order to determine the efficiency of New Hope’s equity capital deployed. Its cost of equity is 8.64%. This means New Hope’s returns actually do not cover its own cost of equity, with a discrepancy of -1.05%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates in return. ROE can be dissected into three distinct 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. The other component, asset turnover, illustrates how much revenue New Hope can make from its 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 New Hope currently has. Currently New Hope has virtually no debt, which means its returns are predominantly driven by equity capital. This could explain why New Hope’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.

Next Steps:

ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. New Hope exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Although, its appropriate level of leverage means investors can be more confident in the sustainability of New Hope’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.

For New Hope, I’ve compiled three key aspects you should further research:

• 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 New Hope 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 New Hope is currently mispriced by the market.

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