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 company’s fundamentals and stock market performance.
ECA Marcellus Trust I’s (NYSE:ECT) most recent return on equity was a substandard 9.5% relative to its industry performance of 13.0% over the past year. Though ECT’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on ECT’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of ECT’s returns.
See our latest analysis for ECA Marcellus Trust I
What you must know about ROE
Return on Equity (ROE) is a measure of ECA Marcellus Trust I’s profit relative to its shareholders’ equity. An ROE of 9.5% implies $0.095 returned on every $1 invested, so the higher the return, the better. Investors seeking to maximise their return in the Oil and Gas Exploration and Production industry may want to choose the highest returning stock. However, this can be deceiving as each company has varying costs of equity and debt levels, which could exaggeratedly push up ROE at the same time as accumulating high interest expense.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of ECA Marcellus Trust I’s equity capital deployed. Its cost of equity is 10.0%. This means ECA Marcellus Trust I’s returns actually do not cover its own cost of equity, with a discrepancy of -0.5%. This isn’t sustainable as it implies, very simply, that the company pays more 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 ECA Marcellus Trust I can make from its 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. ROE can be inflated by disproportionately high levels of debt. This is also unsustainable due to the high interest cost that the company will also incur. Thus, we should look at ECA Marcellus Trust I’s debt-to-equity ratio to examine sustainability of its returns. Currently, ECA Marcellus Trust I has no debt which means its returns are driven purely by equity capital. This could explain why ECA Marcellus Trust I’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. ECA Marcellus Trust I exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For ECA Marcellus Trust I, I’ve compiled three key 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.
- Valuation: What is ECA Marcellus Trust I 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 ECA Marcellus Trust I is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of ECA Marcellus Trust I? 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 past 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. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.