Are Robust Financials Driving The Recent Rally In Harvey Norman Holdings Limited's (ASX:HVN) Stock?

Harvey Norman Holdings (ASX:HVN) has had a great run on the share market with its stock up by a significant 17% over the last three months. Given the company's impressive performance, we decided to study its financial indicators more closely as a company's financial health over the long-term usually dictates market outcomes. Specifically, we decided to study Harvey Norman 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. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

Check out our latest analysis for Harvey Norman Holdings

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 Harvey Norman Holdings is:

20% = AU$733m ÷ AU$3.7b (Based on the trailing twelve months to December 2020).

The 'return' is the yearly profit. One way to conceptualize this is that for each A$1 of shareholders' capital it has, the company made A$0.20 in profit.

What Has ROE Got To Do With 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. 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.

Harvey Norman Holdings' Earnings Growth And 20% ROE

At first glance, Harvey Norman Holdings seems to have a decent ROE. On comparing with the average industry ROE of 6.3% the company's ROE looks pretty remarkable. This certainly adds some context to Harvey Norman Holdings' decent 9.1% net income growth seen over the past five years.

Given that the industry shrunk its earnings at a rate of 0.2% in the same period, the net income growth of the company is quite impressive.

Earnings growth is a huge factor in stock valuation. 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. Has the market priced in the future outlook for HVN? You can find out in our latest intrinsic value infographic research report.

Is Harvey Norman Holdings Efficiently Re-investing Its Profits?

The high three-year median payout ratio of 78% (or a retention ratio of 22%) for Harvey Norman Holdings suggests that the company's growth wasn't really hampered despite it returning most of its income to its shareholders.

Moreover, Harvey Norman Holdings is determined to keep sharing its profits with shareholders which we infer from its long history of paying a dividend for at least ten years. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 78% of its profits over the next three years. However, Harvey Norman Holdings' future ROE is expected to decline to 12% despite there being not much change anticipated in the company's payout ratio.

Summary

On the whole, we feel that Harvey Norman Holdings' performance has been quite good. In particular, its high ROE is quite noteworthy and also the probable explanation behind its considerable earnings growth. Yet, the company is retaining a small portion of its profits. Which means that the company has been able to grow its earnings in spite of it, so that's not too bad. With that said, on studying the latest analyst forecasts, we found that while the company has seen growth in its past earnings, analysts expect its future earnings to shrink. 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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