The Reject Shop Limited's (ASX:TRS) Stock Going Strong But Fundamentals Look Weak: What Implications Could This Have On The Stock?

Most readers would already be aware that Reject Shop's (ASX:TRS) stock increased significantly by 13% over the past month. However, we decided to pay close attention to its weak financials as we are doubtful that the current momentum will keep up, given the scenario. In this article, we decided to focus on Reject Shop's ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Put another way, it reveals the company's success at turning shareholder investments into profits.

See our latest analysis for Reject Shop

How Is ROE Calculated?

Return on equity 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 Reject Shop is:

0.8% = AU$1.1m ÷ AU$143m (Based on the trailing twelve months to June 2020).

The 'return' is the profit over the last twelve months. That means that for every A$1 worth of shareholders' equity, the company generated A$0.01 in profit.

What Has ROE Got To Do With 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. 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 Reject Shop's Earnings Growth And 0.8% ROE

It is hard to argue that Reject Shop's ROE is much good in and of itself. Even when compared to the industry average of 6.6%, the ROE figure is pretty disappointing. Given the circumstances, the significant decline in net income by 47% seen by Reject Shop over the last five years is not surprising. We reckon that there could also be other factors at play here. For instance, the company has a very high payout ratio, or is faced with competitive pressures.

Furthermore, even when compared to the industry, which has been shrinking its earnings at a rate 0.2% in the same period, we found that Reject Shop's performance is pretty disappointing, as it suggests that the company has been shrunk its earnings at a rate faster than the industry.

Earnings growth is an important metric to consider when valuing a stock. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. Doing so will help them establish if the stock's future looks promising or ominous. Is Reject Shop fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Reject Shop Making Efficient Use Of Its Profits?

While the company did payout a portion of its dividend in the past, it currently doesn't pay a dividend. This implies that potentially all of its profits are being reinvested in the business.

Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 37% over the next three years. As a result, the expected drop in Reject Shop's payout ratio explains the anticipated rise in the company's future ROE to 12%, over the same period.

Summary

Overall, we would be extremely cautious before making any decision on Reject Shop. As a result of its low ROE and lack of mich reinvestment into the business, the company has seen a disappointing earnings growth rate. 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 latest analysts predictions for the company, check out this visualization of analyst forecasts 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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