Stock Analysis

Is Cairn Energy PLC's (LON:CNE) ROE Of 10.55% Sustainable?

LSE:CNE
Source: Shutterstock

With an ROE of 10.55%, Cairn Energy PLC (LSE:CNE) outpaced its own industry which delivered a less exciting 6.79% over the past year. However, whether this above-industry ROE is actually impressive depends on if it can be maintained. 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 Cairn Energy

Breaking down ROE — the mother of all ratios

Return on Equity (ROE) is a measure of Cairn Energy’s profit relative to its shareholders’ equity. For example, if the company invests £1 in the form of equity, it will generate £0.11 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

Returns are usually compared to costs to measure the efficiency of capital. Cairn Energy’s cost of equity is 8.30%. Given a positive discrepancy of 2.25% between return and cost, this indicates that Cairn Energy pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be dissected into three distinct 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

LSE:CNE Last Perf Apr 20th 18
LSE:CNE Last Perf Apr 20th 18

Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from Cairn Energy’s 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 assess whether Cairn Energy is fuelling ROE by excessively raising debt. Ideally, Cairn Energy should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. The ratio currently stands at a sensible 8.00%, meaning Cairn Energy has not taken on excessive debt to drive its returns. The company is able to produce profit growth without a huge debt burden.

LSE:CNE Historical Debt Apr 20th 18
LSE:CNE Historical Debt Apr 20th 18

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Cairn Energy exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. 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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.

For Cairn Energy, I've put together three fundamental aspects you should further research:

  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. Future Earnings: How does Cairn Energy's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
  3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Cairn 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!

Valuation is complex, but we're helping make it simple.

Find out whether Capricorn Energy is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.

View the Free Analysis

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com

Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.