ReadyTech Holdings' (ASX:RDY) stock is up by a considerable 49% over the past three months. However, we decided to pay attention to the company's fundamentals which don't appear to give a clear sign about the company's financial health. In this article, we decided to focus on ReadyTech Holdings' ROE.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
How To 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 ReadyTech Holdings is:
2.9% = AU$2.2m ÷ AU$75m (Based on the trailing twelve months to June 2021).
The 'return' is the yearly profit. So, this means that for every A$1 of its shareholder's investments, the company generates a profit of A$0.03.
Why Is ROE Important For Earnings Growth?
We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. 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.
ReadyTech Holdings' Earnings Growth And 2.9% ROE
It is quite clear that ReadyTech Holdings' ROE is rather low. Not just that, even compared to the industry average of 10%, the company's ROE is entirely unremarkable. Given the circumstances, the significant decline in net income by 7.3% seen by ReadyTech Holdings over the last five years is not surprising. However, there could also be other factors causing the earnings to decline. Such as - low earnings retention or poor allocation of capital.
That being said, we compared ReadyTech Holdings' performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 18% in the same period.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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. What is RDY worth today? The intrinsic value infographic in our free research report helps visualize whether RDY is currently mispriced by the market.
Is ReadyTech Holdings Using Its Retained Earnings Effectively?
ReadyTech Holdings doesn't pay any dividend, meaning that potentially all of its profits are being reinvested in the business, which doesn't explain why the company's earnings have shrunk if it is retaining all of its profits. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.
Overall, we have mixed feelings about ReadyTech Holdings. Even though it appears to be retaining most of its profits, given the low ROE, investors may not be benefitting from all that reinvestment after all. The low earnings growth suggests our theory correct. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. 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.
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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