The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to better understand how you can grow your money by investing in Natural Resource Partners LP (NYSE:NRP).
Natural Resource Partners LP (NYSE:NRP) outperformed the coal and consumable fuels industry on the basis of its ROE – producing a higher 20.65% relative to the peer average of 11.31% over the past 12 months. But what is more interesting is whether NRP can sustain this above-average ratio. This can be measured by looking at the company’s financial leverage. With more debt, NRP can invest even more and earn more money, thus pushing up its returns. However, ROE only measures returns against equity, not debt. This can be distorted, so let’s take a look at it further. See our latest analysis for Natural Resource Partners
Breaking down Return on Equity
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 20.65% implies $0.21 returned on every $1 invested, so the higher the return, the better. Investors seeking to maximise their return in the Coal and Consumable Fuels industry may want to choose 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
Returns are usually compared to costs to measure the efficiency of capital. Natural Resource Partners’s cost of equity is 17.05%. This means Natural Resource Partners returns enough to cover its own cost of equity, with a buffer of 3.60%. This sustainable practice implies that the company pays less 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover reveals how much revenue can be generated from Natural Resource Partners’s 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. 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 Natural Resource Partners’s debt-to-equity ratio to examine sustainability of its returns. The most recent ratio is 152.14%, which is relatively high, indicating Natural Resource Partners’s above-average ROE is generated by its high leverage and its ability to grow profit hinges on a sizeable debt burden.
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. Natural Resource Partners’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Its high debt level means its strong ROE may be driven by debt funding which raises concerns over the sustainability of Natural Resource Partners’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Natural Resource Partners, I’ve compiled three important 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.
- Valuation: What is Natural Resource Partners worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether Natural Resource Partners is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Natural Resource Partners? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!