The Best Return on Equity in Energy Stocks

Source: SunPower corporate website.

If you are trying to build a portfolio of stocks that is built to grow wealth over the long term, a component of your research is going to have to be getting into the nitty gritty of a company's financials. One component of that research will probably involve looking at a company's returns, and one quick and dirty method of doing that is looking at a company's return on equity.

One thing to remember, though, is that numbers on a financial statement don't always tell the whole truth, and return on equity is no different. So let's take a look at the top 10 companies in the energy space based on their returns on equity and why those numbers aren't all what they seem.

By the numbersEnergy is a pretty expansive space, so instead of focusing on all energy companies, let's look at non-oil and gas such as coal, utilities, and alternative energy --oil and gas deserves its own analysis. Here is a list of the top 10 companies in these parts of the energy world based on their respective returns on equity.

Source: S&P Capital IQ.

Too good to be true?At first glance, these types of returns on capital intense businesses such as coal and utilities are out of this world, and even returns of greater than 20% on alternative energy investments seems like a dream. When you look deeper into the numbers, though, you will see why these numbers aren't what they seem. There are a few ways that companies can have higher than normal returns on equity, and many of the companies on this list exhibit at least one of these traits.

Partnerships don't retain earnings: A large component of a company's equity comes from its retained earnings over the years. In the energy space, however, there is a special type of corporate entity known as a master limited partnership. In exchange for not paying taxes at the corporate level, the company passes a substantial portion of its earnings to its unitholders in the form of a distribution. Since they retain little to any earnings, the equity that is held on the books in proportionally smaller to its size. This applies to any company on this list that has an LP at the end of it.
Retained losses: Not only does a company retain its earnings over time, it also retains any earnings losses over time. When companies do massive asset value write downs, goodwill impairments, or just go through a few years of losses, this counts against its retained earnings. If these losses are great enough, they can make a company's return on equity look fantastic once net income turns back into the black. Canadian Solar and JinkoSolar are both on this list in part because of taking retained losses recently. For Canadian Solar and JinkoSolar, these accumulated losses meant that last year's total equity was only $560 million and $450 million, respectively, despite both companies being valued on the market for much more.
High debt load: One thing that allows a company to generate higher returns on equity is to simply just have a lower percentage of the company's capital structure in equity compared to its debt. This is common for companies in the utility space because utility revenues have historically been very predictable. The four companies on this list also just happen to have rather high debt to capital ratios:

Source:S&P Capital IQ.

Covering your basesIf anything, this list should go to show that a company's return on equity should be taken with a small grain of salt because it might not tell the whole story at the company. One alternative option for measuring returns for a company in the energy space is to look at return on assets. Most energy companies are asset heavy companies, so looking at how their assets perform can give a little bit more accurate measure of what is going on. Return on assets figures can be skewed as well by things such as asset writedowns, but it is a little harder to manipulate than return on equity. Here is how all of the companies listed above stack up on a return on asset basis.

Source:S&P Capital IQ.

None of the companies really stack up compared to their returns on equity, but Alliance Resources Partners and its holding company, Alliance Holdings GP, still seem to perform quite well, especially considering its business (coal mining).

What a Fool believesLooking at return on equity can be a great way for determining whether a company is worthy of your investment dollars... sometimes. There are, however, several instances where the return on equity figure for a respective company might not tell the whole story. High debt level utility companies, limited partnership companies that avoid retaining equity, and companies with recent histories of big losses can look much more attractive than they really are, so investors should be sure to look into what drives those numbers before making any big investment decisions.

The article The Best Return on Equity in Energy Stocks originally appeared on Fool.com.

Tyler Crowe has no position in any stocks mentioned.You can follow him at Fool.comor on Twitter:@TylerCroweFool. The Motley Fool recommends Alliance Resource Partners and National Grid. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.