ECA Marcellus Trust I (NYSE:ECT) outperformed the Oil and Gas Exploration and Production industry on the basis of its ROE – producing a higher 10.72% relative to the peer average of 9.36% over the past 12 months. On the surface, this looks fantastic since we know that ECT has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable ECT’s ROE is. Check out our latest analysis for ECA Marcellus Trust I
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of ECT’s profit relative to its shareholders’ equity. It essentially shows how much ECT 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
Returns are usually compared to costs to measure the efficiency of capital. ECT’s cost of equity is 8.85%. Given a positive discrepancy of 1.86% between return and cost, this indicates that ECT pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be broken down into three different 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 ECT can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable ECT’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine ECT’s debt-to-equity level. Currently, ECT 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.
What this means for you:
Are you a shareholder? ECT exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.
Are you a potential investor? If ECT has been on your watch list for a while, making an investment decision based on ROE alone is unwise. I recommend you do additional fundamental analysis by looking through our most recent infographic report on ECA Marcellus Trust I to help you make a more informed investment decision.
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.