Carrizo Oil & Gas Inc (NASDAQ:CRZO) delivered an ROE of 17.17% over the past 12 months, which is an impressive feat relative to its industry average of 10.21% during the same period. Superficially, this looks great since we know that CRZO has generated big profits with little equity capital; however, ROE doesn’t tell us how much CRZO has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable CRZO’s ROE is. See our latest analysis for Carrizo Oil & Gas
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Carrizo Oil & Gas’s profit relative to its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.17 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 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 Carrizo Oil & Gas, which is 12.35%. Since Carrizo Oil & Gas’s return covers its cost in excess of 4.82%, its use of equity capital is efficient and likely to be sustainable. Simply put, Carrizo Oil & Gas pays less for its capital than what it generates 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
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 Carrizo Oil & Gas 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 inflated by excessive debt, we need to examine Carrizo Oil & Gas’s debt-to-equity level. Currently the debt-to-equity ratio stands at more than 2.5 times, which means its above-average ROE is driven by significant debt levels.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Carrizo Oil & Gas’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Its high debt level means its strong ROE may be driven by debt funding which raises concerns over the sustainability of Carrizo Oil & Gas’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.