With an ROE of 106.26%, Anglo African Oil & Gas Plc (AIM:AAOG) outpaced its own industry which delivered a less exciting 6.16% over the past year. Though, the impressiveness of AAOG’s ROE is contingent on whether this industry-beating level can be sustained. A measure of sustainable returns is AAOG’s financial leverage. If AAOG borrows debt to invest in its business, its profits will be higher. But ROE does not capture any debt, so we only see high profits and low equity, which is great on the surface. But today let’s take a deeper dive below this surface. See our latest analysis for AAOG
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of AAOG’s profit relative to its shareholders’ equity. For example, if AAOG invests £1 in the form of equity, it will generate £1.06 in earnings from this. 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 AAOG 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 AAOG, which is 8.30%. Given a positive discrepancy of 97.96% between return and cost, this indicates that AAOG 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient AAOG is with its cost management. Asset turnover shows how much revenue AAOG can generate with its current 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 AAOG’s capital structure is. We can assess whether AAOG is fuelling ROE by excessively raising debt. Ideally, AAOG should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. Currently, AAOG 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. AAOG’s ROE is impressive relative to the industry average and also covers 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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Anglo African Oil & Gas, there are three relevant factors you should look at:
1. 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.
2. Valuation: What is AAOG 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 AAOG is currently mispriced by the market.
3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of AAOG? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!