How Did Northland Power Inc’s (TSX:NPI) 31.52% ROE Fare Against The Industry?
Northland Power Inc (TSX:NPI) delivered an ROE of 31.52% over the past 12 months, which is an impressive feat relative to its industry average of 4.28% during the same period. Superficially, this looks great since we know that NPI has generated big profits with little equity capital; however, ROE doesn’t tell us how much NPI has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether NPI’s ROE is actually sustainable. View our latest analysis for Northland Power
What you must know about ROE
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if NPI invests $1 in the form of equity, it will generate $0.32 in earnings from this. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. NPI’s cost of equity is 10.51%. Since NPI’s return covers its cost in excess of 21.01%, its use of equity capital is efficient and likely to be sustainable. Simply put, NPI 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue NPI can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable NPI’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt NPI currently has. Currently the debt-to-equity ratio stands at more than 2.5 times, which means its above-average ROE is driven by significant debt levels.
What this means for you:
Are you a shareholder? NPI exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. However, with debt capital in excess of equity, ROE might be inflated by the use of debt funding, which is something you should be aware of before buying more NPI shares. 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 you are considering investing in NPI, looking at ROE on its own is not enough to make a well-informed decision. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Northland Power 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.
