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This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Tullow Oil plc (LON:TLW) delivered a less impressive 8.3% ROE over the past year, compared to the 11.8% return generated by its industry. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into TLW’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of TLW’s returns. Let me show you what I mean by this.
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What you must know about ROE
Return on Equity (ROE) weighs Tullow Oil’s profit against the level of its shareholders’ equity. An ROE of 8.3% implies £0.083 returned on every £1 invested. 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 Tullow Oil, which is 12.0%. Given a discrepancy of -3.7% between return and cost, this indicated that Tullow Oil may be paying more for its capital than what it’s generating in return. ROE can be dissected into three distinct 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. The other component, asset turnover, illustrates how much revenue Tullow Oil can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt Tullow Oil currently has. Currently the debt-to-equity ratio stands at a high 191%, which means its below-average ROE is already being driven by significant debt levels.