Rice Midstream Partners LP’s (NYSE:RMP) most recent return on equity was a substandard 7.62% relative to its industry performance of 11.31% over the past year. 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 RMP’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of RMP’s returns. Check out our latest analysis for Rice Midstream Partners
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Rice Midstream Partners’s profit relative to its shareholders’ equity. An ROE of 7.62% implies $0.08 returned on every $1 invested. 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 Rice Midstream Partners, which is 9.80%. Given a discrepancy of -2.18% between return and cost, this indicated that Rice Midstream Partners may be paying more for its capital than what it’s generating 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from Rice Midstream Partners’s 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 Rice Midstream Partners currently has. Currently the debt-to-equity ratio stands at a low 12.77%, which means Rice Midstream Partners still has headroom to take on more leverage in order to increase profits.
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. Rice Midstream Partners’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.