Occidental Petroleum Corporation’s (NYSE:OXY) most recent return on equity was a substandard 2.54% relative to its industry performance of 9.06% over the past year. Though OXY’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on OXY’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of OXY’s returns. Let me show you what I mean by this. View our latest analysis for Occidental Petroleum
What you must know about ROE
Return on Equity (ROE) is a measure of Occidental Petroleum’s profit relative to its shareholders’ equity. An ROE of 2.54% implies $0.03 returned on every $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. Occidental Petroleum’s cost of equity is 9.01%. This means Occidental Petroleum’s returns actually do not cover its own cost of equity, with a discrepancy of -6.47%. 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 split up into three useful ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:
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 reveals how much revenue can be generated from Occidental Petroleum’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 ROE can be inflated by excessive debt, we need to examine Occidental Petroleum’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 47.54%, which means Occidental Petroleum still has headroom to take on more leverage in order to increase profits.
What this means for you:
Are you a shareholder? OXY exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means OXY still has room to improve shareholder returns by raising debt to fund new investments. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.