The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want a simplistic look at the return on SandRidge Mississippian Trust II (NYSE:SDR) stock.
SandRidge Mississippian Trust II (NYSE:SDR) delivered an ROE of 25.01% over the past 12 months, which is an impressive feat relative to its industry average of 11.31% during the same period. Though, the impressiveness of SDR’s ROE is contingent on whether this industry-beating level can be sustained. Sustainability can be gauged by a company’s financial leverage – the more debt it has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden. Let me show you what I mean by this. See our latest analysis for SandRidge Mississippian Trust II
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs SandRidge Mississippian Trust II’s profit against the level of its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.25 in earnings from this. Investors seeking to maximise their return in the Oil and Gas Exploration and Production industry may want to choose the highest returning stock. But this can be misleading as each company has different costs of equity and also varying debt levels, which could artificially push up ROE whilst accumulating high interest expense.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. SandRidge Mississippian Trust II’s cost of equity is 10.18%. Given a positive discrepancy of 14.83% between return and cost, this indicates that SandRidge Mississippian Trust II pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be dissected into three distinct 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue SandRidge Mississippian Trust II can generate with its current 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 SandRidge Mississippian Trust II’s debt-to-equity ratio to examine sustainability of its returns. Currently, SandRidge Mississippian Trust II has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. SandRidge Mississippian Trust II’s ROE is impressive relative to the industry average and also covers its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. Although ROE can be a useful metric, it is only a small part of diligent research.
For SandRidge Mississippian Trust II, I’ve compiled three fundamental factors you should further examine:
- 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 SandRidge Mississippian Trust II 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 SandRidge Mississippian Trust II is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of SandRidge Mississippian Trust II? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!