With an ROE of 4.75%, Advantage Oil & Gas Ltd (TSX:AAV) returned in-line to its own industry which delivered 6.49% over the past year. But what is more interesting is whether AAV can sustain or improve on this level of return. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of AAV’s returns. View our latest analysis for Advantage Oil & Gas
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Advantage Oil & Gas’s profit against the level of its shareholders’ equity. For example, if the company invests CA$1 in the form of equity, it will generate CA$0.05 in earnings from this. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Oil and Gas Exploration and Production sector by choosing 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 Advantage Oil & Gas 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 Advantage Oil & Gas, which is 9.30%. This means Advantage Oil & Gas’s returns actually do not cover its own cost of equity, with a discrepancy of -4.55%. 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 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover reveals how much revenue can be generated from Advantage Oil & Gas’s 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. We can determine if Advantage Oil & Gas’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 Advantage Oil & Gas’s debt-to-equity ratio. The ratio currently stands at a sensible 17.94%, meaning Advantage Oil & Gas has not taken on excessive debt to drive its returns. The company is able to produce profit growth without a huge debt burden and still has headroom to grow returns to industry average.
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. Advantage Oil & Gas exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Advantage Oil & Gas’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.
For Advantage Oil & Gas, I’ve put together three essential factors you should look at:
- 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 Advantage Oil & Gas 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 Advantage Oil & Gas is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Advantage Oil & Gas? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!