EOG Resources Inc (NYSE:EOG) wants its investors to know that its returns are the best in the oil business. To prove its point, management put together a slide for its investors that compared EOG Resources' returns to its energy industry peers. Take a look.
We could simply take EOG Resources at its word and buy its stock. However, before we do so we need to realize that ROE, or return on equity doesn't actually tell the whole story. That's why I want to take a deeper look at EOG Resources' ROE and compare it to Pioneer Natural Resources (NYSE: PXD), which is one of the E&P peers included in the numbers in the chart from EOG Resources' investor presentation. Pioneer Natural Resources is a good comparison not only because it's on that same chart, but it is the sixth largest pure-play North American onshore oil producer – EOG Resources tops that list – and it operates in many of the same shale basins as EOG Resources.
Drilling down into ROE
ROE is actually a pretty simple formula that helps investors determine how good a company is at generating a return on the equity they have invested with the company. It represents net income divided by shareholder equity. When we compute this for EOG Resources and Pioneer Natural Resources over the last 12 months we get:
As we can see from that chart, EOG Resources really is no match for Pioneer Natural Resources when it comes to earning a return for its investors. However, there is a lot more to this story.
The reason Pioneer Natural Resources' ROE is negative is because it reported a $1.4 billion net loss to end the fourth quarter of 2014. That loss was the result of a $1.5 billion after-tax loss the company booked after writing down assets held for sale as well as the reduction in the carrying value of a natural gas asset. Adjusting for that loss, Pioneer Natural Resources actually earned $140 million that quarter, which would have pushed the company's ROE up to a positive return of 5.14%.
Drilling even deeper
This also highlights the fact that ROE isn't a perfect metric. This is why it's a good idea to dig a little deeper to see if there is anything else impacting ROE. To do this we will use what's called a five step DuPont analysis.
Using this model we can deconstruct the returns of both EOG Resources and Pioneer Natural Resources to see if EOG Resources' ROE is being inflated or if it really is as good as it says it is.
What we see here is that even by using the DuPont Model to deconstruct EOG Resources' ROE, the company still delivers a 15.3% return on equity. It has strong margins, which incidentally are right in line with ConocoPhillips (NYSE: COP), which is another top independent oil and gas company. Meanwhile, it's not overly reliant on leverage to generate those returns, so it's not too risky in its pursuit of investor returns.
In addition to that we also do see that Pioneer Natural Resources' ROE isn't as bad as it seemed at first glance. In fact, the DuPont Model shows that its return is only half as bad as we thought. Further, by adjusting for the write down Pioneer Natural Resources actually is delivering a 5.36% ROE, and its margins are actually 18.8%. Those numbers shouldn't surprise us as the company does produce more natural gas than EOG Resources, which comes with lower margins.
The key takeaway here is to always dig deeper. EOG Resources' management has a very compelling chart in its investor presentation that shows that its ROE is well above its peers. However, as we can see here the ROE of one of the peers it's being compared to is being negatively affected by a large write down. That being said, in this case we still confirm that EOG is doing a fantastic job earning returns for its investors while Pioneer Natural Resources still has some work to do before it's on the same level as EOG Resources.
Matt DiLallo owns shares of ConocoPhillips. The Motley Fool owns shares of EOG Resources. 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.