Does Bega Cheese Limited's (ASX:BGA) Weak Fundamentals Mean That The Market Could Correct Its Share Price?

Bega Cheese's (ASX:BGA) stock is up by a considerable 12% over the past month. We, however wanted to have a closer look at its key financial indicators as the markets usually pay for long-term fundamentals, and in this case, they don't look very promising. In this article, we decided to focus on Bega Cheese's ROE.

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 other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

View our latest analysis for Bega Cheese

How Is ROE Calculated?

ROE 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 Bega Cheese is:

2.6% = AU$21m ÷ AU$814m (Based on the trailing twelve months to June 2020).

The 'return' is the income the business earned over the last year. Another way to think of that is that for every A$1 worth of equity, the company was able to earn A$0.03 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. 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.

A Side By Side comparison of Bega Cheese's Earnings Growth And 2.6% ROE

It is quite clear that Bega Cheese's ROE is rather low. Even when compared to the industry average of 4.8%, the ROE figure is pretty disappointing. For this reason, Bega Cheese's five year net income decline of 10% is not surprising given its lower ROE. However, there could also be other factors causing the earnings to decline. Such as - low earnings retention or poor allocation of capital.

Next, when we compared with the industry, which has shrunk its earnings at a rate of 1.3% in the same period, we still found Bega Cheese's performance to be quite bleak, because the company has been shrinking its earnings faster than the industry.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is BGA fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is Bega Cheese Using Its Retained Earnings Effectively?

Bega Cheese has a high three-year median payout ratio of 101% (that is, it is retaining -0.7% 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. The business is only left with a small pool of capital to reinvest - A vicious cycle that doesn't benefit the company in the long-run.

Moreover, Bega Cheese has been paying dividends for nine years, which is a considerable amount of time, suggesting that management must have perceived that the shareholders prefer consistent dividends even though earnings have been shrinking. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 52% over the next three years. The fact that the company's ROE is expected to rise to 8.2% over the same period is explained by the drop in the payout ratio.

Summary

Overall, we would be extremely cautious before making any decision on Bega Cheese. Particularly, its ROE is a huge disappointment, not to mention its lack of proper reinvestment into the business. As a result its earnings growth has also been quite disappointing. 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. 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.

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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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