Southwest Airlines’ (NYSE:LUV) stock is up by a considerable 15% over the past month. But the company’s key financial indicators appear to be differing across the board and that makes us question whether or not the company’s current share price momentum can be maintained. Particularly, we will be paying attention to Southwest Airlines’ ROE today.
ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company’s shareholders.
How Do You Calculate Return On Equity?
ROE can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders’ Equity
So, based on the above formula, the ROE for Southwest Airlines is:
1.5% = US$163m ÷ US$11b (Based on the trailing twelve months to June 2020).
The ‘return’ is the amount earned after tax over the last twelve months. One way to conceptualize this is that for each $1 of shareholders’ capital it has, the company made $0.01 in profit.
Why Is ROE Important For Earnings Growth?
So far, we’ve learned that ROE is a measure of a company’s profitability. 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. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don’t share these attributes.
A Side By Side comparison of Southwest Airlines’ Earnings Growth And 1.5% ROE
It is hard to argue that Southwest Airlines’ ROE is much good in and of itself. Even compared to the average industry ROE of 6.4%, the company’s ROE is quite dismal. Therefore, Southwest Airlines’ flat earnings over the past five years can possibly be explained by the low ROE amongst other factors.
As a next step, we compared Southwest Airlines’ net income growth with the industry and discovered that the industry saw an average growth of 7.5% in the same period.
Earnings growth is an important metric to consider when valuing a stock. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. This then helps them determine if the stock is placed for a bright or bleak future. Is LUV fairly valued? This infographic on the company’s intrinsic value has everything you need to know.
Is Southwest Airlines Making Efficient Use Of Its Profits?
While the company did pay out a portion of its dividend in the past, it currently doesn’t pay a dividend. We infer that the company has been reinvesting all of its profits to grow its business.
Existing analyst estimates suggest that the company’s future payout ratio is expected to drop to 11% over the next three years. The fact that the company’s ROE is expected to rise to 14% over the same period is explained by the drop in the payout ratio.
On the whole, we feel that the performance shown by Southwest Airlines can be open to many interpretations. Even though it appears to be retaining most of its profits, given the low ROE, investors may not be benefitting from all that reinvestment after all. The low earnings growth suggests our theory correct. That being so, the latest industry analyst forecasts show that the analysts are expecting to see a huge improvement in the company’s earnings growth rate. Are these analysts expectations based on the broad expectations for the industry, or on the company’s fundamentals? Click here to be taken to our analyst’s forecasts page 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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