I am writing today to help inform people who are new to the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
MV Oil Trust (NYSE:MVO) outperformed the Oil and Gas Exploration and Production industry on the basis of its ROE – producing a higher 67.9% relative to the peer average of 13.6% over the past 12 months. Superficially, this looks great since we know that MVO has generated big profits with little equity capital; however, ROE doesn’t tell us how much MVO has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of MVO’s ROE.
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of MV Oil Trust’s profit relative to its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.68 in earnings from this. 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 MV Oil Trust, which is 11.0%. Since MV Oil Trust’s return covers its cost in excess of 56.9%, its use of equity capital is efficient and likely to be sustainable. Simply put, MV Oil Trust pays less for its capital than what it generates in return. 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
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 MV Oil 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 financial leverage can artificially inflate ROE, we need to look at how much debt MV Oil Trust currently has. Currently, MV Oil 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.
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. MV Oil Trust exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For MV Oil Trust, I’ve put together three fundamental factors 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 MV Oil 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 MV Oil Trust is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of MV Oil 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 past 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. For errors that warrant correction please contact the editor at email@example.com.