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 better understand how you can grow your money by investing in Galilee Energy Limited (ASX:GLL).
Galilee Energy Limited (ASX:GLL) outperformed the oil and gas exploration and production industry on the basis of its ROE – producing a higher 62.28% relative to the peer average of 15.13% over the past 12 months. But what is more interesting is whether GLL can sustain this above-average ratio. 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 Galilee Energy
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Galilee Energy’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 misleading as each firm has different costs of equity and debt levels i.e. the more debt Galilee Energy has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Galilee Energy, which is 9.37%. Given a positive discrepancy of 52.91% between return and cost, this indicates that Galilee Energy pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be split up into three useful 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue Galilee Energy can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. 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 Galilee Energy’s debt-to-equity ratio to examine sustainability of its returns. Currently, Galilee Energy 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.
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Galilee Energy’s above-industry ROE is encouraging, and is also in excess of its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For Galilee Energy, 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 Galilee Energy 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 Galilee Energy is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Galilee Energy? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!