This article is intended for those of you who are at the beginning of your investing journey and want to better understand how you can grow your money by investing in Advantage Oil & Gas Ltd (TSE:AAV).
With an ROE of 4.75%, Advantage Oil & Gas Ltd (TSE:AAV) returned in-line to its own industry which delivered 6.50% over the past year. But what is more interesting is whether AAV can sustain or improve on this level of return. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of AAV’s returns. Check out our latest analysis for Advantage Oil & Gas
Breaking down ROE — the mother of all ratios
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$0.048 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 measured against cost of equity in order to determine the efficiency of Advantage Oil & Gas’s equity capital deployed. Its cost of equity is 12.39%. Since Advantage Oil & Gas’s return does not cover its cost, with a difference of -7.64%, this means its current use of equity is not efficient and not sustainable. Very simply, Advantage Oil & Gas 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:
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 Advantage Oil & Gas can make from its asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show 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. Currently the ratio stands at 17.94%, which is very low. This means Advantage Oil & Gas has not taken on leverage, which could explain its below-average ROE. Advantage Oil & Gas still has headroom to take on more leverage in order to grow its returns.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Advantage Oil & Gas’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. 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, there are three key 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 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!