Continental Materials Corporation’s (AMEX:CUO) most recent return on equity was a substandard 3.81% relative to its industry performance of 14.22% 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 CUO's past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of CUO's returns. See our latest analysis for CUO
What you must know about ROE
Return on Equity (ROE) is a measure of CUO’s profit relative to its shareholders’ equity. For example, if CUO invests $1 in the form of equity, it will generate $0.04 in earnings from this. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
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 CUO, which is 11.75%. This means CUO’s returns actually do not cover its own cost of equity, with a discrepancy of -7.94%. This isn’t sustainable as it implies, very simply, that the company pays more 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:
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 CUO can make from its 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 CUO currently has. Currently the debt-to-equity ratio stands at a low 14.31%, which means CUO still has headroom to take on more leverage in order to increase profits.
What this means for you:
Are you a shareholder? CUO’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as CUO still has capacity to improve shareholder returns by borrowing to invest in new projects in the future.
Are you a potential investor? If CUO has been on your watch list for a while, making an investment decision based on ROE alone is unwise. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Continental Materials to help you make a more informed investment decision. If you are not interested in CUO anymore, you can use our free platform to see our list of stocks with Return on Equity over 20%.
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned.