Stock Analysis

Why Occidental Petroleum Corporation (NYSE:OXY) Delivered An Inferior ROE Compared To The Industry

NYSE:OXY
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Occidental Petroleum Corporation (NYSE:OXY) delivered a less impressive 6.37% ROE over the past year, compared to the 10.62% return generated by its industry. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into OXY's past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of OXY's returns. Let me show you what I mean by this. See our latest analysis for Occidental Petroleum

Breaking down Return on Equity

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 $1 in the form of equity, it will generate $0.06 in earnings from this. If investors diversify their portfolio by industry, they may want to maximise their return in the Integrated Oil and Gas sector by investing in 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 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 Occidental Petroleum, which is 9.21%. This means Occidental Petroleum’s returns actually do not cover its own cost of equity, with a discrepancy of -2.83%. 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 split up into three useful 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

NYSE:OXY Last Perf Mar 15th 18
NYSE:OXY Last Perf Mar 15th 18

Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue Occidental Petroleum can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. ROE can be inflated by disproportionately high levels of debt. This is also unsustainable due to the high interest cost that the company will also incur. Thus, we should look at Occidental Petroleum’s debt-to-equity ratio to examine sustainability of its returns. Currently the ratio stands at 47.77%, which is very low. This means Occidental Petroleum has not taken on leverage, which could explain its below-average ROE. Occidental Petroleum still has headroom to take on more leverage in order to grow its returns.

NYSE:OXY Historical Debt Mar 15th 18
NYSE:OXY Historical Debt Mar 15th 18

Next Steps:

ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Occidental Petroleum’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.

For Occidental Petroleum, I've compiled three essential aspects you should further examine:

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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.