Declining Stock and Solid Fundamentals: Is The Market Wrong About McGrath RentCorp (NASDAQ:MGRC)?

McGrath RentCorp (NASDAQ:MGRC) has had a rough three months with its share price down 32%. But if you pay close attention, you might gather that its strong financials could mean that the stock could potentially see an increase in value in the long-term, given how markets usually reward companies with good financial health. Particularly, we will be paying attention to McGrath RentCorp’s 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 short, ROE shows the profit each dollar generates with respect to its shareholder investments.

View our latest analysis for McGrath RentCorp

How Do You Calculate Return On Equity?

The formula for return on equity is:

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

So, based on the above formula, the ROE for McGrath RentCorp is:

15% = US$97m ÷ US$634m (Based on the trailing twelve months to December 2019).

The ‘return’ is the income the business earned over the last year. One way to conceptualize this is that for each $1 of shareholders’ capital it has, the company made $0.15 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. Depending on how much of these profits the company reinvests or “retains”, and how effectively it does so, we are then able to assess a company’s earnings growth potential. 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.

McGrath RentCorp’s Earnings Growth And 15% ROE

To start with, McGrath RentCorp’s ROE looks acceptable. Further, the company’s ROE compares quite favorably to the industry average of 13%. This certainly adds some context to McGrath RentCorp’s exceptional 25% net income growth seen over the past five years. However, there could also be other causes behind this growth. Such as – high earnings retention or an efficient management in place.

We then compared McGrath RentCorp’s 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 13% in the same period.

NasdaqGS:MGRC Past Earnings Growth April 28th 2020
NasdaqGS:MGRC Past Earnings Growth April 28th 2020

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. This then helps them determine if the stock is placed for a bright or bleak future. Is McGrath RentCorp fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is McGrath RentCorp Making Efficient Use Of Its Profits?

McGrath RentCorp has a significant three-year median payout ratio of 56%, meaning the company only retains 44% of its income. This implies that the company has been able to achieve high earnings growth despite returning most of its profits to shareholders.

Besides, McGrath RentCorp has been paying dividends for at least ten years or more. This shows that the company is committed to sharing profits with its shareholders. Existing analyst estimates suggest that the company’s future payout ratio is expected to drop to 40% over the next three years. Despite the lower expected payout ratio, the company’s ROE is not expected to change by much.

Conclusion

Overall, we are quite pleased with McGrath RentCorp’s 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. Having said that, the company’s earnings growth is expected to slow down, as forecasted in the current analyst estimates. 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.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Simply Wall St has no position in the stocks mentioned.

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