Cross Timbers Royalty Trust (NYSE:CRT) outperformed the Oil and Gas Exploration and Production industry on the basis of its ROE – producing a higher 65.02% relative to the peer average of 10.63% over the past 12 months. On the surface, this looks fantastic since we know that CRT has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable CRT’s ROE is. View our latest analysis for Cross Timbers Royalty Trust

Breaking down Return on Equity

Return on Equity (ROE) weighs Cross Timbers Royalty Trust’s profit against the level of its shareholders’ equity. An ROE of 65.02% implies $0.65 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 measured against cost of equity in order to determine the efficiency of Cross Timbers Royalty Trust’s equity capital deployed. Its cost of equity is 10.28%. This means Cross Timbers Royalty Trust returns enough to cover its own cost of equity, with a buffer of 54.73%. This sustainable practice implies that the company 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

Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue Cross Timbers Royalty Trust 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 Cross Timbers Royalty Trust’s debt-to-equity level. Currently, Cross Timbers Royalty Trust 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.

Next Steps:

While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Cross Timbers Royalty Trust exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. Although ROE can be a useful metric, it is only a small part of diligent research.