Eureka Group Holdings (ASX:EGH) has had a great run on the share market with its stock up by a significant 19% over the last three months. Given that stock prices are usually aligned with a company's financial performance in the long-term, we decided to study its financial indicators more closely to see if they had a hand to play in the recent price move. Specifically, we decided to study Eureka Group Holdings' ROE in this article.
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
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 Eureka Group Holdings is:
6.8% = AU$5.9m ÷ AU$88m (Based on the trailing twelve months to December 2020).
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. 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. Assuming everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.
A Side By Side comparison of Eureka Group Holdings' Earnings Growth And 6.8% ROE
When you first look at it, Eureka Group Holdings' ROE doesn't look that attractive. However, the fact that the its ROE is quite higher to the industry average of 5.1% doesn't go unnoticed by us. But then again, seeing that Eureka Group Holdings' net income shrunk at a rate of 6.1% in the past five years, makes us think again. Bear in mind, the company does have a slightly low ROE. It is just that the industry ROE is lower. Hence, this goes some way in explaining the shrinking earnings.
We then compared Eureka Group Holdings' performance with the industry and found that the company has shrunk its earnings at a slower rate than the industry earnings which has seen its earnings shrink by 9.2% in the same period. This does appease the negative sentiment around the company to a certain extent.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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 Eureka Group Holdings is trading on a high P/E or a low P/E, relative to its industry.
Is Eureka Group Holdings Using Its Retained Earnings Effectively?
In spite of a normal three-year median payout ratio of 37% (that is, a retention ratio of 63%), the fact that Eureka Group Holdings' earnings have shrunk is quite puzzling. So there could be some other explanations in that regard. For instance, the company's business may be deteriorating.
Additionally, Eureka Group Holdings 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. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 44% of its profits over the next three years. Accordingly, forecasts suggest that Eureka Group Holdings' future ROE will be 7.2% which is again, similar to the current ROE.
On the whole, we do feel that Eureka Group Holdings has some positive attributes. Yet, the low earnings growth is a bit concerning, especially given that the company has a respectable rate of return and is reinvesting a huge portion of its profits. By the looks of it, there could be some other factors, not necessarily in control of the business, that's preventing growth. 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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