Pacific Energy Limited (ASX:PEA) delivered an ROE of 10.56% over the past 12 months, which is an impressive feat relative to its industry average of 7.41% during the same period. Superficially, this looks great since we know that PEA has generated big profits with little equity capital; however, ROE doesn’t tell us how much PEA has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether PEA’s ROE is actually sustainable. Check out our latest analysis for Pacific Energy

Breaking down Return on Equity

Return on Equity (ROE) weighs Pacific Energy’s profit against the level of its shareholders’ equity. For example, if the company invests A$1 in the form of equity, it will generate A$0.11 in earnings from this. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing 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 Pacific Energy, which is 8.55%. Since Pacific Energy’s return covers its cost in excess of 2.01%, its use of equity capital is efficient and likely to be sustainable. Simply put, Pacific Energy pays less 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 shows how much revenue Pacific Energy can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check Pacific Energy’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a low 29.23%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.

Next Steps:

ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Pacific Energy exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.