Most readers would already know that Top Education Group’s (HKG:1752) stock increased by 9.8% over the past three months. However, we decided to study the company’s mixed-bag of fundamentals to assess what this could mean for future share prices, as stock prices tend to be aligned with a company’s long-term financial performance. Particularly, we will be paying attention to Top Education Group’s 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 simpler terms, it measures the profitability of a company in relation to shareholder’s equity.
How Is ROE Calculated?
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 Top Education Group is:
8.4% = AU$4.3m ÷ AU$51m (Based on the trailing twelve months to December 2019).
The ‘return’ is the profit over the last twelve months. Another way to think of that is that for every HK$1 worth of equity, the company was able to earn HK$0.08 in profit.
What Is The Relationship Between ROE And 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. 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.
Top Education Group’s Earnings Growth And 8.4% ROE
At first glance, Top Education Group’s ROE doesn’t look very promising. Next, when compared to the average industry ROE of 11%, the company’s ROE leaves us feeling even less enthusiastic. Given the circumstances, the significant decline in net income by 4.5% seen by Top Education Group over the last five years is not surprising. However, there could also be other factors causing the earnings to decline. For instance, the company has a very high payout ratio, or is faced with competitive pressures.
So, as a next step, we compared Top Education Group’s performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 19% in the same period.
Earnings growth is an important metric to consider when valuing a stock. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. 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 Top Education Group is trading on a high P/E or a low P/E, relative to its industry.
Is Top Education Group Making Efficient Use Of Its Profits?
Despite having a normal three-year median payout ratio of 44% (where it is retaining 56% of its profits), Top Education Group has seen a decline in earnings as we saw above. So there could be some other explanations in that regard. For instance, the company’s business may be deteriorating.
Additionally, Top Education Group started paying a dividend only recently. So it looks like the management may have perceived that shareholders favor dividends even though earnings have been in decline.
On the whole, we feel that the performance shown by Top Education Group 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. Wrapping up, we would proceed with caution with this company and one way of doing that would be to look at the risk profile of the business. Our risks dashboard would have the 3 risks we have identified for Top Education Group.
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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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