This analysis is intended to introduce important early concepts to people who are starting to invest and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
ECA Marcellus Trust I (NYSE:ECT) delivered a less impressive 9.5% ROE over the past year, compared to the 13.1% return generated by its industry. ECT’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 ECT’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of ECT’s returns.
Breaking down Return on Equity
Return on Equity (ROE) weighs ECA Marcellus Trust I’s profit against the level of its shareholders’ equity. An ROE of 9.5% implies $0.095 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
ROE is measured against cost of equity in order to determine the efficiency of ECA Marcellus Trust I’s equity capital deployed. Its cost of equity is 10.9%. This means ECA Marcellus Trust I’s returns actually do not cover its own cost of equity, with a discrepancy of -1.4%. 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 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover shows how much revenue ECA Marcellus Trust I can generate with its current 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 ECA Marcellus Trust I currently has. Currently, ECA Marcellus Trust I has no debt which means its returns are driven purely by equity capital. This could explain why ECA Marcellus Trust I’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. ECA Marcellus Trust I’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.
For ECA Marcellus Trust I, I’ve compiled three key 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 ECA Marcellus 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 ECA Marcellus Trust I is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of ECA Marcellus 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 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.