Is Weakness In BSA Limited (ASX:BSA) Stock A Sign That The Market Could be Wrong Given Its Strong Financial Prospects?

With its stock down 16% over the past three months, it is easy to disregard BSA (ASX:BSA). However, a closer look at its sound financials might cause you to think again. Given that fundamentals usually drive long-term market outcomes, the company is worth looking at. In this article, we decided to focus on BSA's ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

See our latest analysis for BSA

How Do You Calculate Return On Equity?

The formula for ROE is:

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

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

24% = AU$7.8m ÷ AU$32m (Based on the trailing twelve months to June 2020).

The 'return' is the yearly profit. Another way to think of that is that for every A$1 worth of equity, the company was able to earn A$0.24 in profit.

What Is The Relationship Between ROE And Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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.

BSA's Earnings Growth And 24% ROE

Firstly, we acknowledge that BSA has a significantly high ROE. Secondly, even when compared to the industry average of 14% the company's ROE is quite impressive. So, the substantial 40% net income growth seen by BSA over the past five years isn't overly surprising.

As a next step, we compared BSA's net income growth with the industry, and pleasingly, we found that the growth seen by the company is higher than the average industry growth of 4.5%.

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. 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 BSA is trading on a high P/E or a low P/E, relative to its industry.

Is BSA Using Its Retained Earnings Effectively?

The three-year median payout ratio for BSA is 40%, which is moderately low. The company is retaining the remaining 60%. This suggests that its dividend is well covered, and given the high growth we discussed above, it looks like BSA is reinvesting its earnings efficiently.

Additionally, BSA has paid dividends over a period of at least ten years which means that the company is pretty serious about sharing its profits with shareholders. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 32% of its profits over the next three years. As a result, BSA's ROE is not expected to change by much either, which we inferred from the analyst estimate of 27% for future ROE.

Summary

Overall, we are quite pleased with BSA's performance. In particular, it's great to see that the company is investing heavily into its business and along with a high rate of return, that has resulted in a sizeable growth in its earnings. Having said that, the company's earnings growth is expected to slow down, as forecasted in the current analyst estimates. 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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