With an ROE of 10.21%, New Concept Energy Inc (AMEX:GBR) returned in-line to its own industry which delivered 10.60% over the past year. But what is more interesting is whether GBR can sustain or improve on this level of return. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of GBR’s returns. Check out our latest analysis for New Concept Energy
Peeling the layers of ROE – trisecting a company’s profitability
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.1 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 misleading as each firm has different costs of equity and debt levels i.e. the more debt New Concept Energy 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
Returns are usually compared to costs to measure the efficiency of capital. New Concept Energy’s cost of equity is 8.79%. Some of New Concept Energy’s peers may have a higher ROE but its cost of equity could exceed this return, leading to an unsustainable negative discrepancy i.e. the company spends more than it earns. This is not the case for New Concept Energy which is reassuring. 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
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 New Concept Energy’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. We can determine if New Concept Energy’s ROE is inflated by borrowing high levels of debt. Generally, a balanced capital structure means its returns will be sustainable over the long run. We can examine this by looking at New Concept Energy’s debt-to-equity ratio. The ratio currently stands at a sensible 10.36%, meaning New Concept 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.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Even though New Concept Energy returned below the industry average, its ROE comes in excess of its cost of equity. Its appropriate level of leverage means investors can be more confident in the sustainability of New Concept Energy’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 New Concept Energy, I’ve compiled three important aspects you should look at below. Just a heads up – to access some parts of the Simply Wall St research tool you might be asked to create a free account, but it takes just one click and the information they provide is definitely worth it in my opinion.
- 1. Financial Health: Does it have a healthy balance sheet? Take a look at this free balance sheet analysis with six simple checks on key factors like leverage and risk.
- 2. Future Earnings: How does New Concept 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 Simply Wall St’s free analyst growth expectation chart.
- 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of New Concept Energy? Explore this interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!