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Many investors are still learning about the various metrics that can be useful when analysing a stock. This article is for those who would like to learn about Return On Equity (ROE). We'll use ROE to examine Northland Power Inc. (TSE:NPI), by way of a worked example.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Put another way, it reveals the company's success at turning shareholder investments into profits.
Check out our latest analysis for Northland Power
How To Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Northland Power is:
8.2% = CA$371m ÷ CA$4.6b (Based on the trailing twelve months to December 2024).
The 'return' is the profit over the last twelve months. Another way to think of that is that for every CA$1 worth of equity, the company was able to earn CA$0.08 in profit.
Does Northland Power Have A Good ROE?
Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. As is clear from the image below, Northland Power has a lower ROE than the average (13%) in the Renewable Energy industry.
That certainly isn't ideal. However, a low ROE is not always bad. If the company's debt levels are moderate to low, then there's still a chance that returns can be improved via the use of financial leverage. A high debt company having a low ROE is a different story altogether and a risky investment in our books. Our risks dashboard should have the 2 risks we have identified for Northland Power.
The Importance Of Debt To Return On Equity
Virtually all companies need money to invest in the business, to grow profits. That cash can come from retained earnings, issuing new shares (equity), or debt. In the case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the debt used for growth will improve returns, but won't affect the total equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Northland Power's Debt And Its 8.2% ROE
Northland Power clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.59. With a fairly low ROE, and significant use of debt, it's hard to get excited about this business at the moment. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.