This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Archer Limited (OB:ARCHER) outperformed the oil and gas drilling industry on the basis of its ROE – producing a higher 43.61% relative to the peer average of 6.34% over the past 12 months. 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.
Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests NOK1 in the form of equity, it will generate NOK0.44 in earnings from this. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Oil and Gas Drilling sector by choosing the highest returning stock. However, this can be deceiving as each company has varying costs of equity and debt levels, which could exaggeratedly push up ROE at the same time as 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 Archer’s equity capital deployed. Its cost of equity is 18.01%. Since Archer’s return covers its cost in excess of 25.60%, its use of equity capital is efficient and likely to be sustainable. Simply put, Archer pays less 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. The other component, asset turnover, illustrates how much revenue Archer can make from its 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 assess whether Archer is fuelling ROE by excessively raising debt. Ideally, Archer should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. Currently the ratio stands at more than 2.5 times, which is very high. This means Archer’s above-average ROE is being driven by its significant debt levels and its ability to grow profit hinges on a significant debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Archer’s ROE is impressive relative to the industry average and also covers its cost of equity. With debt capital in excess of equity, ROE may be inflated by the use of debt funding, raising questions over the sustainability of the company’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Archer, there are three essential factors you should further research:
- 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 Archer 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 Archer is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Archer? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.