Barnwell Industries Inc (AMEX:BRN) delivered an ROE of 14.50% over the past 12 months, which is an impressive feat relative to its industry average of 9.28% during the same period. Though, the impressiveness of BRN’s ROE is contingent on whether this industry-beating level can be sustained. 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 Barnwell Industries
Peeling the layers of ROE – trisecting a company’s profitability
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 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 Barnwell Industries 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 Barnwell Industries, which is 8.49%. Given a positive discrepancy of 6.00% between return and cost, this indicates that Barnwell Industries 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:
ROE = profit margin × asset turnover × financial leverage
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = annual net profit ÷ shareholders’ equity
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from Barnwell Industries’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 determine if Barnwell Industries’s ROE is inflated by borrowing high levels of debt. Generally, a balanced capital structure means its returns will be sustainable over the long run. We can examine this by looking at Barnwell Industries’s debt-to-equity ratio. Currently, Barnwell Industries 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.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Barnwell Industries’s above-industry ROE is encouraging, and is also in excess of 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 Barnwell Industries, I’ve put together three relevant 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 Barnwell Industries 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 Barnwell Industries is currently mispriced by the market.
- 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Barnwell Industries? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!