Ricardo (LON:RCDO) has had a rough three months with its share price down 25%. However, the company’s fundamentals look pretty decent, and long-term financials are usually aligned with future market price movements. Particularly, we will be paying attention to Ricardo’s ROE today.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
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 Ricardo is:
11% = UK£18m ÷ UK£163m (Based on the trailing twelve months to June 2020).
The ‘return’ is the amount earned after tax over the last twelve months. That means that for every £1 worth of shareholders’ equity, the company generated £0.11 in profit.
What Has ROE Got To Do With Earnings Growth?
Thus far, we have learned that ROE measures how efficiently a company is generating its profits. We now need to evaluate how much profit the company reinvests or “retains” for future growth which then gives us an idea about the growth potential of the company. 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.
Ricardo’s Earnings Growth And 11% ROE
To start with, Ricardo’s ROE looks acceptable. And on comparing with the industry, we found that the the average industry ROE is similar at 14%. As you might expect, the 5.0% net income decline reported by Ricardo is a bit of a surprise. So, there might be some other aspects that could explain this. For example, it could be that the company has a high payout ratio or the business has allocated capital poorly, for instance.
However, when we compared Ricardo’s growth with the industry we found that while the company’s earnings have been shrinking, the industry has seen an earnings growth of 14% in the same period. This is quite worrisome.
Earnings growth is a huge factor in stock valuation. 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. One good indicator of expected earnings growth is the P/E ratio which determines the price the market is willing to pay for a stock based on its earnings prospects. So, you may want to check if Ricardo is trading on a high P/E or a low P/E, relative to its industry.
Is Ricardo Making Efficient Use Of Its Profits?
With a high three-year median payout ratio of 60% (implying that 40% of the profits are retained), most of Ricardo’s profits are being paid to shareholders, which explains the company’s shrinking earnings. With only very little left to reinvest into the business, growth in earnings is far from likely. To know the 3 risks we have identified for Ricardo visit our risks dashboard for free.
Existing analyst estimates suggest that the company’s future payout ratio is expected to drop to 41% over the next three years. As a result, the expected drop in Ricardo’s payout ratio explains the anticipated rise in the company’s future ROE to 16%, over the same period.
Overall, we feel that Ricardo certainly does have some positive factors to consider. Yet, the low earnings growth is a bit concerning, especially given that the company has a high rate of return. Investors could have benefitted from the high ROE, had the company been reinvesting more of its earnings. As discussed earlier, the company is retaining a small portion of its profits. 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. 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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