Why North Energy ASA’s (OB:NORTH) ROE Of 3.20% Does Not Tell The Whole Story

I am writing today to help inform people who are new to the stock market and want to better understand how you can grow your money by investing in North Energy ASA (OB:NORTH).

North Energy ASA (OB:NORTH) delivered a less impressive 3.20% ROE over the past year, compared to the 8.53% return generated by its industry. 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 NORTH’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of NORTH’s returns. View out our latest analysis for North Energy

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

Return on Equity (ROE) is a measure of North Energy’s profit relative to its shareholders’ equity. For example, if the company invests NOK1 in the form of equity, it will generate NOK0.032 in earnings from this. If investors diversify their portfolio by industry, they may want to maximise their return in the Oil and Gas Exploration and Production sector by investing in the highest returning stock. However, this can be deceiving as each company has varying costs of equity and debt levels, which could exaggeratedly push up ROE at the same time as accumulating high interest expense.

Return on Equity = Net Profit ÷ Shareholders Equity

ROE is measured against cost of equity in order to determine the efficiency of North Energy’s equity capital deployed. Its cost of equity is 8.40%. Given a discrepancy of -5.20% between return and cost, this indicated that North Energy may be paying more for its capital than what it’s generating 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

OB:NORTH Last Perf June 26th 18
OB:NORTH Last Perf June 26th 18

Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from North Energy’s 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 the company’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 North Energy’s debt-to-equity ratio to examine sustainability of its returns. The ratio currently stands at a sensible 8.85%, meaning North Energy has not taken on excessive debt to drive its returns. The company is able to produce profit growth without a huge debt burden and still has headroom to grow returns to industry average.

OB:NORTH Historical Debt June 26th 18
OB:NORTH Historical Debt June 26th 18

Next Steps:

ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. North Energy’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. 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. Although ROE can be a useful metric, it is only a small part of diligent research.

For North Energy, I’ve compiled three important factors 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. Management:Have insiders been ramping up their shares to take advantage of the market’s sentiment for North Energy’s future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
  3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of North 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!