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Beach Energy Limited (ASX:BPT) outperformed the Oil and Gas Exploration and Production industry on the basis of its ROE – producing a higher 21.53% relative to the peer average of 17.04% over the past 12 months. Superficially, this looks great since we know that BPT has generated big profits with little equity capital; however, ROE doesn’t tell us how much BPT has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of BPT’s ROE. See our latest analysis for Beach Energy
What you must know about ROE
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests A$1 in the form of equity, it will generate A$0.22 in earnings from this. 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
ROE is measured against cost of equity in order to determine the efficiency of Beach Energy’s equity capital deployed. Its cost of equity is 8.68%. Since Beach Energy’s return covers its cost in excess of 12.85%, its use of equity capital is efficient and likely to be sustainable. Simply put, Beach Energy 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:
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 Beach Energy’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 financial leverage can artificially inflate ROE, we need to look at how much debt Beach Energy currently has. Currently, Beach Energy 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.