Collins Foods Limited's (ASX:CKF) On An Uptrend But Financial Prospects Look Pretty Weak: Is The Stock Overpriced?

Collins Foods' (ASX:CKF) stock is up by a considerable 28% over the past three months. However, we decided to pay close attention to its weak financials as we are doubtful that the current momentum will keep up, given the scenario. Specifically, we decided to study Collins Foods' ROE in this article.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

See our latest analysis for Collins Foods

How Is ROE Calculated?

Return on equity 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 Collins Foods is:

7.3% = AU$30m ÷ AU$414m (Based on the trailing twelve months to October 2023).

The 'return' is the amount earned after tax over the last twelve months. Another way to think of that is that for every A$1 worth of equity, the company was able to earn A$0.07 in profit.

Why Is ROE Important For Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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.

Collins Foods' Earnings Growth And 7.3% ROE

When you first look at it, Collins Foods' ROE doesn't look that attractive. Yet, a closer study shows that the company's ROE is similar to the industry average of 6.9%. Having said that, Collins Foods' five year net income decline rate was 5.4%. Bear in mind, the company does have a slightly low ROE. Hence, this goes some way in explaining the shrinking earnings.

From the 5.4% decline reported by the industry in the same period, we infer that Collins Foods and its industry are both shrinking at a similar rate.

Earnings growth is a huge factor in stock valuation. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). This then helps them determine if the stock is placed for a bright or bleak future. Has the market priced in the future outlook for CKF? You can find out in our latest intrinsic value infographic research report.

Is Collins Foods Efficiently Re-investing Its Profits?

Collins Foods has a high three-year median payout ratio of 73% (that is, it is retaining 27% of its profits). This suggests that the company is paying most of its profits as dividends to its shareholders. This goes some way in explaining why its earnings have been shrinking. With only a little being reinvested into the business, earnings growth would obviously be low or non-existent. To know the 2 risks we have identified for Collins Foods visit our risks dashboard for free.

In addition, Collins Foods has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 55% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 19%, over the same period.

Conclusion

In total, we would have a hard think before deciding on any investment action concerning Collins Foods. The company has seen a lack of earnings growth as a result of retaining very little profits and whatever little it does retain, is being reinvested at a very low rate of return. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.