I am writing today to help inform people who are new to the stock market and looking to gauge the potential return on investment in MEG Energy Corp (TSE:MEG).
With an ROE of 7.41%, MEG Energy Corp (TSE:MEG) returned in-line to its own industry which delivered 6.50% over the past year. However, whether this ROE is actually impressive depends on if it can be maintained. This can be measured by looking at the company’s financial leverage. With more debt, MEG 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 MEG Energy
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs MEG Energy’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$0.074 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. 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
ROE is measured against cost of equity in order to determine the efficiency of MEG Energy’s equity capital deployed. Its cost of equity is 17.66%. This means MEG Energy’s returns actually do not cover its own cost of equity, with a discrepancy of -10.25%. 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue MEG Energy can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can determine if MEG Energy’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 MEG Energy’s debt-to-equity ratio. The ratio currently stands at a sensible 86.53%, meaning MEG Energy has not taken on excessive debt to drive its returns. The company is able to produce profit growth without a huge debt burden.
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. MEG Energy exhibits a strong ROE against its peers, however it was not high enough to cover its own cost of equity this year. 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 MEG Energy, I’ve put together 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 MEG 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 MEG Energy is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of MEG 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!