SandRidge Mississippian Trust I (NYSE:SDT) outperformed the Oil and Gas Exploration and Production industry on the basis of its ROE – producing a higher 20.49% relative to the peer average of 10.63% over the past 12 months. While the impressive ratio tells us that SDT has made significant profits from little equity capital, ROE doesn’t tell us if SDT has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether SDT’s ROE is actually sustainable. See our latest analysis for SandRidge Mississippian Trust I
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs SandRidge Mississippian Trust I’s profit against the level of its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.2 in earnings from this. 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
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 SandRidge Mississippian Trust I, which is 10.30%. Since SandRidge Mississippian Trust I’s return covers its cost in excess of 10.19%, its use of equity capital is efficient and likely to be sustainable. Simply put, SandRidge Mississippian Trust I 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from SandRidge Mississippian Trust I’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt SandRidge Mississippian Trust I currently has. Currently, SandRidge Mississippian Trust I 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. SandRidge Mississippian Trust I’s ROE is impressive relative to the industry average and also covers 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 SandRidge Mississippian Trust I, there are 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 SandRidge Mississippian Trust I 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 SandRidge Mississippian Trust I is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of SandRidge Mississippian Trust I? 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.