With an ROE of 5.98%, Genesis Energy Limited (NZSE:GNE) outpaced its own industry which delivered a less exciting 5.56% over the past year. On the surface, this looks fantastic since we know that GNE has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether GNE’s ROE is actually sustainable. Check out our latest analysis for Genesis Energy
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Genesis Energy’s profit relative to its shareholders’ equity. An ROE of 5.98% implies NZ$0.06 returned on every NZ$1 invested. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Genesis Energy, which is 8.55%. Since Genesis Energy’s return does not cover its cost, with a difference of -2.58%, this means its current use of equity is not efficient and not sustainable. Very simply, Genesis Energy pays more 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue Genesis Energy can generate with its current 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. Since ROE can be artificially increased through excessive borrowing, we should check Genesis Energy’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a reasonable 63.57%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.
What this means for you:
Are you a shareholder? GNE’s ROE is impressive relative to the industry average, though its returns were not strong enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means GNE still has room to improve shareholder returns by raising debt to fund new investments. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.
Are you a potential investor? If GNE has been on your watch list for a while, making an investment decision based on ROE alone is unwise. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Genesis Energy to help you make a more informed investment decision.
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned.