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What is Behind Neste Oyj’s (HEL:NESTE) Superior ROE?

Felix Olson

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 begin learning the link between Neste Oyj (HEL:NESTE)’s return fundamentals and stock market performance.

Neste Oyj (HEL:NESTE) delivered an ROE of 22.70% over the past 12 months, which is an impressive feat relative to its industry average of 10.55% during the same period. Superficially, this looks great since we know that NESTE has generated big profits with little equity capital; however, ROE doesn’t tell us how much NESTE has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether NESTE’s ROE is actually sustainable. See our latest analysis for Neste Oyj

Breaking down ROE — the mother of all ratios

Return on Equity (ROE) weighs Neste Oyj’s profit against the level of its shareholders’ equity. For example, if the company invests €1 in the form of equity, it will generate €0.23 in earnings from this. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.

Return on Equity = Net Profit ÷ Shareholders Equity

ROE is measured against cost of equity in order to determine the efficiency of Neste Oyj’s equity capital deployed. Its cost of equity is 8.16%. This means Neste Oyj returns enough to cover its own cost of equity, with a buffer of 14.54%. This sustainable practice implies that the company pays less 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:

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

HLSE:NESTE Last Perf June 25th 18

The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from Neste Oyj’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check Neste Oyj’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 25.61%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.

HLSE:NESTE Historical Debt June 25th 18

Next Steps:

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. Neste Oyj exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.

For Neste Oyj, I’ve compiled three key factors 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. Valuation: What is Neste Oyj 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 Neste Oyj is currently mispriced by the market.
  3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Neste Oyj? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!

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.