Natural Gas Services Group Inc (NYSE:NGS) delivered a less impressive 0.97% ROE over the past year, compared to the 6.64% return generated by its industry. NGS’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on NGS’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of NGS’s returns. View our latest analysis for Natural Gas Services Group
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 the company invests $1 in the form of equity, it will generate $0.01 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
Returns are usually compared to costs to measure the efficiency of capital. Natural Gas Services Group’s cost of equity is 8.67%. Since Natural Gas Services Group’s return does not cover its cost, with a difference of -7.69%, this means its current use of equity is not efficient and not sustainable. Very simply, Natural Gas Services Group 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
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 Natural Gas Services Group’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. Since financial leverage can artificially inflate ROE, we need to look at how much debt Natural Gas Services Group currently has. Currently Natural Gas Services Group has virtually no debt, which means its returns are predominantly driven by equity capital. This could explain why Natural Gas Services Group’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
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 Gas Services Group’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Natural Gas Services Group’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.
For Natural Gas Services Group, I’ve put together three pertinent factors 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.
Management:Have insiders been ramping up their shares to take advantage of the market’s sentiment for Natural Gas Services Group’s future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Natural Gas Services Group? 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.