What is Behind Sprague Resources LP’s (NYSE:SRLP) Superior ROE?
With an ROE of 26.09%, Sprague Resources LP (NYSE:SRLP) outpaced its own industry which delivered a less exciting 10.69% over the past year. Superficially, this looks great since we know that SRLP has generated big profits with little equity capital; however, ROE doesn’t tell us how much SRLP has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of SRLP’s ROE. See our latest analysis for Sprague Resources
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Sprague Resources’s profit against the level of its 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 Sprague Resources, which is 12.13%. This means Sprague Resources returns enough to cover its own cost of equity, with a buffer of 13.95%. This sustainable practice implies that the company pays less 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue Sprague Resources can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check Sprague Resources’s historic debt-to-equity ratio. At over 2.5 times, Sprague Resources’s debt-to-equity ratio is very high and indicates the above-average ROE is generated by significant leverage levels.
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. Sprague Resources’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Its high debt level means its strong ROE may be driven by debt funding which raises concerns over the sustainability of Sprague Resources’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Sprague Resources, I’ve put together three important aspects 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 Sprague Resources 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 Sprague Resources is currently mispriced by the market.
Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Sprague Resources? 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.
