This analysis is intended to introduce important early concepts to people who are starting to invest and want a simplistic look at the return on Advantage Oil & Gas Ltd (TSE:AAV) stock.
Advantage Oil & Gas Ltd (TSE:AAV) delivered a less impressive 4.75% ROE over the past year, compared to the 6.50% return generated by its industry. AAV’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on AAV’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of AAV’s returns. Let me show you what I mean by this. See our latest analysis for Advantage Oil & Gas
Breaking down Return on Equity
Return on Equity (ROE) weighs Advantage Oil & Gas’s profit against the level of its shareholders’ equity. An ROE of 4.75% implies CA$0.048 returned on every CA$1 invested. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Advantage Oil & Gas’s cost of equity is 12.47%. This means Advantage Oil & Gas’s returns actually do not cover its own cost of equity, with a discrepancy of -7.71%. 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. Asset turnover shows how much revenue Advantage Oil & Gas 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 inflated by excessive debt, we need to examine Advantage Oil & Gas’s debt-to-equity level. At 17.94%, Advantage Oil & Gas’s debt-to-equity ratio appears low and indicates that Advantage Oil & Gas still has room to increase leverage and grow its profits.
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 underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Advantage Oil & Gas’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Advantage Oil & Gas, I’ve put together three key aspects you should look at:
- 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.