Adairs Limited's (ASX:ADH) Stock Is Going Strong: Is the Market Following Fundamentals?

Adairs' (ASX:ADH) stock is up by a considerable 56% over the past three months. Given that the market rewards strong financials in the long-term, we wonder if that is the case in this instance. Particularly, we will be paying attention to Adairs' ROE today.

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

Check out our latest analysis for Adairs

How Is ROE Calculated?

The formula for ROE is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Adairs is:

25% = AU$35m ÷ AU$141m (Based on the trailing twelve months to June 2020).

The 'return' is the yearly profit. One way to conceptualize this is that for each A$1 of shareholders' capital it has, the company made A$0.25 in profit.

What Has ROE Got To Do With Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. Assuming all else is equal, companies that have both a higher return on equity and higher profit retention are usually the ones that have a higher growth rate when compared to companies that don't have the same features.

A Side By Side comparison of Adairs' Earnings Growth And 25% ROE

Firstly, we acknowledge that Adairs has a significantly high ROE. Second, a comparison with the average ROE reported by the industry of 17% also doesn't go unnoticed by us. This probably laid the groundwork for Adairs' moderate 19% net income growth seen over the past five years.

We then compared Adairs' net income growth with the industry and we're pleased to see that the company's growth figure is higher when compared with the industry which has a growth rate of 8.5% in the same period.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. Doing so will help them establish if the stock's future looks promising or ominous. If you're wondering about Adairs''s valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Adairs Making Efficient Use Of Its Profits?

Adairs has a significant three-year median payout ratio of 65%, meaning that it is left with only 35% to reinvest into its business. This implies that the company has been able to achieve decent earnings growth despite returning most of its profits to shareholders.

Moreover, Adairs is determined to keep sharing its profits with shareholders which we infer from its long history of five years of paying a dividend. Based on the latest analysts' estimates, we found that the company's future payout ratio over the next three years is expected to hold steady at 71%. Accordingly, forecasts suggest that Adairs' future ROE will be 28% which is again, similar to the current ROE.

Conclusion

In total, we are pretty happy with Adairs' performance. In particular, its high ROE is quite noteworthy and also the probable explanation behind its considerable earnings growth. Yet, the company is retaining a small portion of its profits. Which means that the company has been able to grow its earnings in spite of it, so that's not too bad. That being so, a study of the latest analyst forecasts show that the company is expected to see a slowdown in its future earnings growth. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.

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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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