Why North Energy ASA's (OB:NORTH) ROE Of 6.70% Does Not Tell The Whole Story

North Energy ASA (OB:NORTH) generated a below-average return on equity of 6.70% in the past 12 months, while its industry returned 10.36%. NORTH's results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on NORTH’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of NORTH's returns. See our latest analysis for North Energy

Breaking down Return on Equity

Return on Equity (ROE) weighs North Energy’s profit against the level of its shareholders’ equity. An ROE of 6.70% implies NOK0.07 returned on every NOK1 invested, so the higher the return, the better. 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 misleading as each firm has different costs of equity and debt levels i.e. the more debt North Energy has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.

Returns are usually compared to costs to measure the efficiency of capital. North Energy’s cost of equity is 8.40%. Since North Energy’s return does not cover its cost, with a difference of -1.70%, this means its current use of equity is not efficient and not sustainable. Very simply, North Energy pays more for its capital than what it generates 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:

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 North Energy can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can assess whether North Energy is fuelling ROE by excessively raising debt. Ideally, North Energy should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. The most recent ratio is 8.25%, which is sensible and indicates North Energy has not taken on too much leverage. Thus, we can conclude its below-average ROE may be a result of low debt, and North Energy still has room to increase leverage and grow future returns.

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. North Energy’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of North Energy’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.

For North Energy, I've put together 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. Future Earnings: How does North Energy's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
• 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!

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Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.