SandRidge Permian Trust (NYSE:PER) outperformed the Oil and Gas Exploration and Production industry on the basis of its ROE – producing a higher 20.34% relative to the peer average of 10.65% over the past 12 months. Superficially, this looks great since we know that PER has generated big profits with little equity capital; however, ROE doesn’t tell us how much PER has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether PER’s ROE is actually sustainable. See our latest analysis for SandRidge Permian Trust
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs SandRidge Permian Trust’s profit against the level of its shareholders’ equity. An ROE of 20.34% implies $0.2 returned on every $1 invested. 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. SandRidge Permian Trust’s cost of equity is 10.30%. Given a positive discrepancy of 10.03% between return and cost, this indicates that SandRidge Permian Trust 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 SandRidge Permian Trust can make from its 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 ROE can be artificially increased through excessive borrowing, we should check SandRidge Permian Trust’s historic debt-to-equity ratio. Currently, SandRidge Permian 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. SandRidge Permian Trust’s above-industry ROE is encouraging, and is also in excess of 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 Permian Trust, I’ve put together three important factors 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 SandRidge Permian 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 SandRidge Permian Trust is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of SandRidge Permian 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.