NZ Windfarms Limited (NZSE:NWF) delivered a less impressive 3.34% ROE over the past year, compared to the 6.87% return generated by its industry. Though NWF’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on NWF’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of NWF’s returns. See our latest analysis for NZ Windfarms
What you must know about ROE
Return on Equity (ROE) is a measure of NZ Windfarms’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Investors seeking to maximise their return in the Renewable Electricity industry may want to choose 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 NZ Windfarms has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of NZ Windfarms’s equity capital deployed. Its cost of equity is 8.55%. Since NZ Windfarms’s return does not cover its cost, with a difference of -5.21%, this means its current use of equity is not efficient and not sustainable. Very simply, NZ Windfarms pays more for its capital than what it generates in return. ROE can be dissected into three distinct 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
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 NZ Windfarms can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. We can assess whether NZ Windfarms is fuelling ROE by excessively raising debt. Ideally, NZ Windfarms 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 20.94%, which is sensible and indicates NZ Windfarms has not taken on too much leverage. Thus, we can conclude its below-average ROE may be a result of low debt, and NZ Windfarms still has room to increase leverage and grow future returns.
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. NZ Windfarms’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 NZ Windfarms’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For NZ Windfarms, I’ve compiled three pertinent aspects you should further research:
- 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.
- Future Earnings: How does NZ Windfarms’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.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of NZ Windfarms? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!