Advantage Oil & Gas Ltd (TSX:AAV) outperformed the Oil and Gas Exploration and Production industry on the basis of its ROE – producing a higher 7.25% relative to the peer average of 5.96% over the past 12 months. While the impressive ratio tells us that AAV has made significant profits from little equity capital, ROE doesn’t tell us if AAV has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable AAV’s ROE is. View our latest analysis for Advantage Oil & Gas
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. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
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 Advantage Oil & Gas, which is 11.89%. This means Advantage Oil & Gas’s returns actually do not cover its own cost of equity, with a discrepancy of -4.65%. 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:
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. The other component, asset turnover, illustrates how much revenue Advantage Oil & Gas 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. Since financial leverage can artificially inflate ROE, we need to look at how much debt Advantage Oil & Gas currently has. At 15.93%, Advantage Oil & Gas’s debt-to-equity ratio appears low and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Advantage Oil & Gas’s ROE is impressive relative to the industry average, though its returns were not strong enough to cover its own cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of industry-beating returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For Advantage Oil & Gas, there are three relevant 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 Advantage Oil & Gas 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 Advantage Oil & Gas is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Advantage Oil & Gas? 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 pass 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.