Lovisa Holdings Limited's (ASX:LOV) Stock's Been Going Strong: Could Weak Financials Mean The Market Will Correct Its Share Price?

Lovisa Holdings' (ASX:LOV) stock is up by a considerable 31% over the past month. However, in this article, we decided to focus on its weak fundamentals, as long-term financial performance of a business is what ultimatley dictates market outcomes. In this article, we decided to focus on Lovisa Holdings' ROE.

ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

Check out our latest analysis for Lovisa 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 Lovisa Holdings is:

6.9% = AU$4.1m ÷ AU$59m (Based on the trailing twelve months to December 2020).

The 'return' is the amount earned after tax over the last twelve months. So, this means that for every A$1 of its shareholder's investments, the company generates a profit of A$0.07.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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. 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.

Lovisa Holdings' Earnings Growth And 6.9% ROE

At first glance, Lovisa Holdings' ROE doesn't look very promising. A quick further study shows that the company's ROE doesn't compare favorably to the industry average of 19% either. Hence, the flat earnings seen by Lovisa Holdings over the past five years could probably be the result of it having a lower ROE.

Next, on comparing with the industry net income growth, we found that the industry grew its earnings by6.6% in the same period.

Earnings growth is a huge factor in stock valuation. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. Doing so will help them establish if the stock's future looks promising or ominous. Has the market priced in the future outlook for LOV? You can find out in our latest intrinsic value infographic research report.

Is Lovisa Holdings Making Efficient Use Of Its Profits?

The high three-year median payout ratio of 92% (meaning, the company retains only 8.0% of profits) for Lovisa Holdings suggests that the company's earnings growth was miniscule as a result of paying out a majority of its earnings.

In addition, Lovisa Holdings has been paying dividends over a period of six 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 73% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 68%, over the same period.

Conclusion

On the whole, Lovisa Holdings' performance is quite a big let-down. 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. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.

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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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