Navios Maritime Midstream Partners LP’s (NYSE:NAP) most recent return on equity was a substandard 6.11% relative to its industry performance of 9.36% over the past year. 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 NAP’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of NAP’s returns. Let me show you what I mean by this. See our latest analysis for NAP
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of NAP’s profit relative to its shareholders’ equity. An ROE of 6.11% implies $0.06 returned on every $1 invested, so the higher the return, the better. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Oil and Gas Storage and Transportation sector by choosing the highest returning stock. But this can be misleading as each company has different costs of equity and also varying debt levels, which could artificially push up ROE whilst accumulating high interest expense.
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 NAP, which is 14.11%. Since NAP’s return does not cover its cost, with a difference of -7.99%, this means its current use of equity is not efficient and not sustainable. Very simply, NAP pays more 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:
ROE = profit margin × asset turnover × financial leverage
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = annual net profit ÷ shareholders’ equity
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue NAP can generate with its current 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 NAP’s capital structure is. ROE can be inflated by disproportionately high levels of debt. This is also unsustainable due to the high interest cost that the company will also incur. Thus, we should look at NAP’s debt-to-equity ratio to examine sustainability of its returns. Currently the ratio stands at 75.51%, which is reasonable. This means NAP has not taken on too much leverage, and its current ROE is driven by its ability to grow its profit without a huge debt burden.
Why is ROE called the mother of all ratios
ROE is called the mother of all ratios for a reason. It helps gauge a company’s efficiency by looking at both its income statement and balance sheet. NAP exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. There are other important measures we need to consider in order to conclude on the quality of its returns. I recommend you see our latest FREE analysis report to find out more about these measures!
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