SandRidge Mississippian Trust I (NYSE:SDT) Delivered A Better ROE Than The Industry, Here’s Why

SandRidge Mississippian Trust I (NYSE:SDT) outperformed the oil and gas exploration and production industry on the basis of its ROE – producing a higher 19.94% relative to the peer average of 9.06% over the past 12 months. But what is more interesting is whether SDT can sustain this above-average ratio. A measure of sustainable returns is SDT’s financial leverage. If SDT borrows debt to invest in its business, its profits will be higher. But ROE does not capture any debt, so we only see high profits and low equity, which is great on the surface. But today let’s take a deeper dive below this surface. See our latest analysis for SandRidge Mississippian Trust I

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 $1 in the form of equity, it will generate $0.2 in earnings from this. Investors seeking to maximise their return in the Oil and Gas Exploration and Production 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.

ROE is measured against cost of equity in order to determine the efficiency of SandRidge Mississippian Trust I’s equity capital deployed. Its cost of equity is 10.09%. This means SandRidge Mississippian Trust I returns enough to cover its own cost of equity, with a buffer of 9.85%. This sustainable practice implies that the company pays less 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:

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 SandRidge Mississippian Trust I’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can assess whether SandRidge Mississippian Trust I is fuelling ROE by excessively raising debt. Ideally, SandRidge Mississippian Trust I should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. Currently, SandRidge Mississippian Trust I 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.

Next Steps:

While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. SandRidge Mississippian Trust I’s ROE is impressive relative to the industry average and also covers 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 SandRidge Mississippian Trust I, I've put together three relevant factors you should look at:

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 SandRidge Mississippian Trust I 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 SandRidge Mississippian Trust I is currently mispriced by the market.

3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of SandRidge Mississippian Trust I? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!

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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.