Chesapeake Granite Wash Trust (NYSE:CHKR) delivered an ROE of 51.82% over the past 12 months, which is an impressive feat relative to its industry average of 11.36% during the same period. Superficially, this looks great since we know that CHKR has generated big profits with little equity capital; however, ROE doesn’t tell us how much CHKR has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether CHKR’s ROE is actually sustainable. Check out our latest analysis for Chesapeake Granite Wash Trust
What you must know about ROE
Return on Equity (ROE) weighs Chesapeake Granite Wash Trust’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. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Chesapeake Granite Wash Trust’s cost of equity is 10.17%. Since Chesapeake Granite Wash Trust’s return covers its cost in excess of 41.65%, its use of equity capital is efficient and likely to be sustainable. Simply put, Chesapeake Granite Wash Trust 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:
ROE = profit margin × asset turnover × financial leverage
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = annual net profit ÷ shareholders’ equity
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 Chesapeake Granite Wash Trust’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. Since ROE can be inflated by excessive debt, we need to examine Chesapeake Granite Wash Trust’s debt-to-equity level. Currently, Chesapeake Granite Wash Trust 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. Chesapeake Granite Wash Trust exhibits a strong ROE against its peers, as well as sufficient returns to cover 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. Although ROE can be a useful metric, it is only a small part of diligent research.
For Chesapeake Granite Wash Trust, I’ve compiled three essential aspects you should further examine:
- 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 Chesapeake Granite Wash Trust 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 Chesapeake Granite Wash Trust is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Chesapeake Granite Wash Trust? 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.