With an ROE of 19.96%, Seadrill Partners LLC (NYSE:SDLP) outpaced its own industry which delivered a less exciting 1.92% over the past year. But what is more interesting is whether SDLP can sustain this above-average ratio. This can be measured by looking at the company’s financial leverage. With more debt, SDLP can invest even more and earn more money, thus pushing up its returns. However, ROE only measures returns against equity, not debt. This can be distorted, so let’s take a look at it further. See our latest analysis for SDLP
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of SDLP’s profit relative to its shareholders’ equity. For example, if SDLP invests $1 in the form of equity, it will generate $0.2 in earnings from this. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Oil and Gas Drilling sector by choosing 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. SDLP’s cost of equity is 17.53%. Given a positive discrepancy of 2.43% between return and cost, this indicates that SDLP pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be broken down into three different 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. The other component, asset turnover, illustrates how much revenue SDLP can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable SDLP’s capital structure is. We can determine if SDLP’s ROE is inflated by borrowing high levels of debt. Generally, a balanced capital structure means its returns will be sustainable over the long run. We can examine this by looking at SDLP’s debt-to-equity ratio. Currently the ratio stands at 133.70%, which is relatively balanced. This means SDLP has not taken on excessive leverage, and its above-average ROE is driven by its ability to grow its profit without a significant debt burden.
ROE – More than just a profitability ratio
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. SDLP’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. However, there are other crucial measures we need to account for before determining whether or not its returns are sustainable. I recommend you see our latest FREE analysis report to find out more about other measures!
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