Chesapeake Energy Corporation (NYSE:CHK) is the second largest natural gas producer in America's lower 48 states. Devon Energy Corp. (NYSE:DVN), meanwhile, has now slipped to fifth place as it's more focused on oil. Because of this focus on oil Devon Energy beats Chesapeake Energy hands down when it comes to oil production. In fact, Devon Energy is now the second largest onshore pure-play oil producer in North America while Chesapeake Energy comes in a distant fourth, as it produces half the oil of Devon Energy.
So, clearly we have two of the top oil and gas producers in the U.S. The question that needs to be answered is which is doing a better job earning returns for investors. Let's explore this by drilling down into the return on equity, or ROE, these energy giants are generating for investors.
Drilling down into returns
ROE is a simple metric that tells investors how well a company does at reinvesting its income to generate earnings growth. It's equal to the net income divided by total shareholder equity. It's a particularly important number for energy investors because these companies tend to reinvest nearly all of their profits to drill new wells. So, it gives investors a gauge of how well a company is doing at earning a return on the money investors have entrusted management to grow.
Here's a look at the ROE of Chesapeake Energy and Devon Energy based on trailing 12-month income and average shareholder equity over that same period:
As the above comparison clearly shows, Devon Energy is whipping Chesapeake Energy when it comes to earning its investors a return on their equity. However, before we walk away from this little exercise and declare Devon Energy king, we need to first realize that return on equity has its shortcomings. It can be affected by things such as debt or stock buybacks, which could skew ROE. So, let's take a deeper look by using a DuPont Model to deconstruct the ROE of both companies.
Drilling down even further
The following graphic shows the five step DuPont Model, which breaks down ROE by taking into consideration things like taxes and debt.
Now, using that model as our guide here's what the ROE for both companies would look like all else being equal.
What we see by deconstructing the ROE of both companies confirms that Devon Energy really does beat Chesapeake Energy in earning returns for its investors. However, by deconstructing ROE using the DuPont Model we've also learned that Chesapeake Energy is doing a better job than the simple ROE led us to believe.
One of the factors helping Devon Energy earn higher returns is clearly seen in its pre-interest, pretax margins, which are well above those of Chesapeake Energy. This is the result of Devon Energy's higher margin oil production. Clearly its focus on drilling oil wells is paying off.
The other takeaway we can glean from this is the fact that debt actually doesn't have as big of an impact on Chesapeake Energy as we would think. This is despite the fact that the company's issues with debt have been well documented in the past. One reason for this is the fact that Chesapeake Energy really has cut a substantial amount of debt over the past year.
What's most clear from this is the fact that Devon Energy's investments to grow its oil production are clearly paying off for investors as it's earning higher returns than its natural gas focused peer Chesapeake Energy. That being said, Chesapeake Energy is also investing to boost its own production of higher margin liquids like oil. So, investors should keep a close eye to see if Chesapeake Energy can boost its ROE in the future the way it has done so for Devon Energy.
Matt DiLallo has no position in any stocks mentioned. The Motley Fool owns shares of Devon Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.