Adacel Technologies Limited's (ASX:ADA) Fundamentals Look Pretty Strong: Could The Market Be Wrong About The Stock?

It is hard to get excited after looking at Adacel Technologies' (ASX:ADA) recent performance, when its stock has declined 12% over the past week. However, stock prices are usually driven by a company’s financials over the long term, which in this case look pretty respectable. Specifically, we decided to study Adacel Technologies' ROE in this article.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

See our latest analysis for Adacel Technologies

How Do You Calculate Return On Equity?

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 Adacel Technologies is:

37% = AU$7.3m ÷ AU$20m (Based on the trailing twelve months to June 2021).

The 'return' is the amount earned after tax over the last twelve months. One way to conceptualize this is that for each A$1 of shareholders' capital it has, the company made A$0.37 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.

Adacel Technologies' Earnings Growth And 37% ROE

Firstly, we acknowledge that Adacel Technologies has a significantly high ROE. Second, a comparison with the average ROE reported by the industry of 10% also doesn't go unnoticed by us. Needless to say, we are quite surprised to see that Adacel Technologies' net income shrunk at a rate of 21% over the past five years. So, there might be some other aspects that could explain this. These include low earnings retention or poor allocation of capital.

So, as a next step, we compared Adacel Technologies' performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 17% in the same period.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). This then helps them determine if the stock is placed for a bright or bleak future. 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 Adacel Technologies is trading on a high P/E or a low P/E, relative to its industry.

Is Adacel Technologies Efficiently Re-investing Its Profits?

With a high three-year median payout ratio of 50% (implying that 50% of the profits are retained), most of Adacel Technologies' profits are being paid to shareholders, which explains the company's shrinking earnings. The business is only left with a small pool of capital to reinvest - A vicious cycle that doesn't benefit the company in the long-run. You can see the 4 risks we have identified for Adacel Technologies by visiting our risks dashboard for free on our platform here.

Additionally, Adacel Technologies has paid dividends over a period of seven years, which means that the company's management is rather focused on keeping up its dividend payments, regardless of the shrinking earnings. Looking at the current analyst consensus data, we can see that the company's future payout ratio is expected to rise to 71% over the next three years. Therefore, the expected rise in the payout ratio explains why the company's ROE is expected to decline to 29% over the same period.

Summary

Overall, we feel that Adacel Technologies certainly does have some positive factors to consider. However, while the company does have a high ROE, its earnings growth number is quite disappointing. This can be blamed on the fact that it reinvests only a small portion of its profits and pays out the rest as dividends. Until now, we have only just grazed the surface of the company's past performance by looking at the company's fundamentals. You can do your own research on Adacel Technologies and see how it has performed in the past by looking at this FREE detailed graph of past earnings, revenue and cash flows.

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.

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