Owens-Illinois Inc (NYSE:OI) outperformed the Metal and Glass Containers industry on the basis of its ROE – producing a higher 36.59% relative to the peer average of 16.69% over the past 12 months. Superficially, this looks great since we know that OI has generated big profits with little equity capital; however, ROE doesn’t tell us how much OI has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of OI’s ROE. View our latest analysis for Owens-Illinois
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. It essentially shows how much OI can generate in earnings given the amount of equity it has raised. 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 OI, which is 17.53%. This means OI returns enough to cover its own cost of equity, with a buffer of 19.06%. This sustainable practice implies that the company pays less 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue OI can make from its asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable OI’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check OI’s historic debt-to-equity ratio. At over 2.5 times, OI’s debt-to-equity ratio is very high and indicates the above-average ROE is generated by significant leverage levels.
What this means for you:
Are you a shareholder? OI exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. However, its high debt level appears to be the driver of a strong ROE and is something you should be mindful of before adding more of OI to your portfolio. 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 OI 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 Owens-Illinois 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.