Why Seadrill Partners LLC’s (NYSE:SDLP) ROE Of 4.20% Does Not Tell The Whole Story

The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and looking to gauge the potential return on investment in Seadrill Partners LLC (NYSE:SDLP).

Seadrill Partners LLC (NYSE:SDLP) delivered an ROE of 4.20% over the past 12 months, which is relatively in-line with its industry average of 6.75% during the same period. But what is more interesting is whether SDLP can sustain or improve on this level of return. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of SDLP’s returns. Let me show you what I mean by this. Check out our latest analysis for Seadrill Partners

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. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Investors seeking to maximise their return in the Oil and Gas Drilling industry may want to choose 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. Seadrill Partners’s cost of equity is 17.05%. This means Seadrill Partners’s returns actually do not cover its own cost of equity, with a discrepancy of -12.86%. 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 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

NYSE:SDLP Last Perf June 26th 18
NYSE:SDLP Last Perf June 26th 18

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 Seadrill Partners 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. 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 Seadrill Partners’s debt-to-equity ratio to examine sustainability of its returns. The most recent ratio is 123.86%, which is relatively proportionate and indicates Seadrill Partners has not taken on extreme leverage. Thus, we can conclude its current ROE is generated from its capacity to increase profit without a massive debt burden.

NYSE:SDLP Historical Debt June 26th 18
NYSE:SDLP Historical Debt June 26th 18

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Seadrill Partners exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. 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 Seadrill Partners, there are three fundamental aspects you should further examine:

  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 Seadrill Partners 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 Seadrill Partners is currently mispriced by the market.
  3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Seadrill Partners? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!