Cooper Tire & Rubber Company’s (NYSE:CTB) most recent return on equity was a substandard 8.16% relative to its industry performance of 13.50% over the past year. Though CTB’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on CTB’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of CTB’s returns. Check out our latest analysis for Cooper Tire & Rubber

Peeling the layers of ROE – trisecting a company’s profitability

Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 8.16% implies $0.08 returned on every $1 invested. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.

Return on Equity = Net Profit ÷ Shareholders Equity

Returns are usually compared to costs to measure the efficiency of capital. Cooper Tire & Rubber’s cost of equity is 11.05%. Given a discrepancy of -2.89% between return and cost, this indicated that Cooper Tire & Rubber may be paying more for its capital than what it’s generating in return. ROE can be broken down into three different ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:

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. Asset turnover shows how much revenue Cooper Tire & Rubber can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine Cooper Tire & Rubber’s debt-to-equity level. At 28.41%, Cooper Tire & Rubber’s debt-to-equity ratio appears low and indicates that Cooper Tire & Rubber still has room to increase leverage and grow its profits.

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Cooper Tire & Rubber’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Cooper Tire & Rubber’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.