Declining Stock and Solid Fundamentals: Is The Market Wrong About Harvey Norman Holdings Limited (ASX:HVN)?

Harvey Norman Holdings (ASX:HVN) has had a rough three months with its share price down 5.7%. However, stock prices are usually driven by a company’s financial performance over the long term, which in this case looks quite promising. In this article, we decided to focus on Harvey Norman Holdings' 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. Put another way, it reveals the company's success at turning shareholder investments into profits.

Check out our latest analysis for Harvey Norman Holdings

How Do You Calculate Return On Equity?

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:

12% = AU$547m ÷ AU$4.5b (Based on the trailing twelve months to June 2023).

The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each A$1 of shareholders' capital it has, the company made A$0.12 in profit.

What Is The Relationship Between ROE And Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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. 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 Harvey Norman Holdings' Earnings Growth And 12% ROE

To start with, Harvey Norman Holdings' ROE looks acceptable. And on comparing with the industry, we found that the the average industry ROE is similar at 12%. Consequently, this likely laid the ground for the decent growth of 15% seen over the past five years by Harvey Norman Holdings.

As a next step, we compared Harvey Norman Holdings' net income growth with the industry and found that the company has a similar growth figure when compared with the industry average growth rate of 15% in the same period.

Earnings growth is an important metric to consider when valuing a stock. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). Doing so will help them establish if the stock's future looks promising or ominous. 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 Using Its Retained Earnings Effectively?

The high three-year median payout ratio of 54% (or a retention ratio of 46%) for Harvey Norman Holdings suggests that the company's growth wasn't really hampered despite it returning most of its income to its shareholders.

Besides, Harvey Norman Holdings has been paying dividends for at least ten years or more. This shows that the company is committed to sharing profits with its shareholders. Our latest analyst data shows that the future payout ratio of the company is expected to rise to 74% over the next three years. Consequently, the higher expected payout ratio explains the decline in the company's expected ROE (to 9.4%) over the same period.

Conclusion

Overall, we are quite pleased with Harvey Norman Holdings' performance. Especially the high ROE, Which has contributed to the impressive growth seen in earnings. Despite the company reinvesting only a small portion of its profits, it still has managed to grow its earnings so that is appreciable. Having said that, on studying current analyst estimates, we were concerned to see that while the company has grown its earnings in the past, analysts expect its earnings to shrink in the future. 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. 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.