New Hope Corporation Limited (ASX:NHC) generated a below-average return on equity of 7.80% in the past 12 months, while its industry returned 13.91%. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into NHC’s past performance. 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

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

Return on Equity (ROE) is a measure of NHC’s profit relative to its shareholders’ equity. An ROE of 7.80% 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 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 NHC, which is 8.55%. Given a discrepancy of -0.75% between return and cost, this indicated that NHC may be paying more for its capital than what it’s generating in return. ROE can be broken down into three different 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 NHC is with its cost management. The other component, asset turnover, illustrates how much revenue NHC can make from its 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 NHC’s debt-to-equity level. Currently NHC has virtually no debt, which means its returns are predominantly driven by equity capital. This could explain why NHC’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.

What this means for you:

Are you a shareholder? NHC exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as NHC still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. 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 NHC has been on your watch list for a while, making an investment decision based on ROE alone is unwise. I recommend you do additional fundamental analysis by looking through our most recent infographic report on New Hope 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.