Core Molding Technologies Inc’s (AMEX:CMT) most recent return on equity was a substandard 6.85% relative to its industry performance of 14.58% 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 CMT’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of CMT’s returns. Let me show you what I mean by this. See our latest analysis for CMT
Breaking down Return on Equity
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if CMT invests $1 in the form of equity, it will generate $0.07 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
Returns are usually compared to costs to measure the efficiency of capital. CMT’s cost of equity is 10.39%. This means CMT’s returns actually do not cover its own cost of equity, with a discrepancy of -3.53%. 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 dissected into three distinct 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 CMT can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable CMT’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine CMT’s debt-to-equity level. The debt-to-equity ratio currently stands at a low 7.35%, meaning CMT still has headroom to borrow debt to increase profits.
What this means for you:
Are you a shareholder? CMT’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 CMT still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.
Are you a potential investor? If you are considering investing in CMT, basing your decision on ROE alone is certainly not sufficient. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Core Molding Technologies to help you make a more informed investment decision.
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.