With 12.1% ROE in the last year, DCP Midstream Partners LP (NYSE:DPM) appeared more efficient when we look at the industry average of 6.6% ROE. However, we must not ignore the role of leverage, which artificially inflates an ROE, making a poor performance look outstanding. See our latest analysis for DPM
What you must know about ROE
ROE ratio basically calculates the net income as a percentage of total capital committed by shareholders, namely shareholders’ equity. Any ROE north of 20%, implying 20 cents return on every dollar invested, is favourable for any investor. But investors seek multiple assets to diversify risk and an industry-specific comparison makes more sense to achieve the goal of choosing the best among a given lot.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE above the cost of equity estimate indicates value creation, which apparently is the only reason shares rally. The cost of equity can be estimated through a popular and Nobel-prize winning method called Capital Asset Pricing Model (CAPM). With a few sets of assumptions, the CAPM pegs DPM’s cost of equity at 8.44%, compared to its ROE of 12.1%. When we break down ROE using a very popular method called Dupont Formula, it unfolds into three key ratios which are responsible for a company’s profitability: net profit margin, asset turnover, and financial leverage. While higher margin and asset turnover indicate improved efficiency, investors should be cautious about the impact of increased leverage.
ROE = annual net profit ÷ shareholders’ equity
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = profit margin × asset turnover × financial leverage
A trend of profit growing faster than revenue is indicative of improvement in ROE. While investors should assess the past correlation between them, an assessment of the analysts’ profit and revenue forecast points to the most likely scenario going forward. The asset turnover for a capital intensive industry such as bricks-and-mortar retail would be substantially lower than the e-commerce retail industry. A comparison with the industry can be drawn through ROA, which represents earnings as a percentage of assets. DCP Midstream Partners’s ROA stood at 2.1% in the past year, compared to the industry’s 1.94%.
The impact of leverage on ROE is reflected in a company’s debt-equity profile. Rapidly rising debt compared to equity, while profit margin and asset turnover underperform, raises a red flag on the ROE. It’s important as a company can inflate its ROE by consistently increasing debt despite weak operating performance. DPM’s debt to equity ratio currently stands at 0.83. Investors should be cautious about any sharp change in this ratio, more so if it’s due to increasing debt.
Why is ROE called the mother of all ratios
While ROE can be calculated through a very simple calculation, investors should look at various ratios by breaking it down and how each of them affects the return to understand the strengths and weakness of a company. It’s one of the few ratios which stitches together performance metrics from the income statement and the balance sheet. What are the analysts’ projection of DCP Midstream Partners’s ROE in three years? I recommend you see our latest FREE analysis report to find out!
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