Do Its Financials Have Any Role To Play In Driving Xero Limited's (ASX:XRO) Stock Up Recently?

Xero's (ASX:XRO) stock is up by a considerable 19% over the past three months. Given that stock prices are usually aligned with a company's financial performance in the long-term, we decided to study its financial indicators more closely to see if they had a hand to play in the recent price move. Specifically, we decided to study Xero's 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 short, ROE shows the profit each dollar generates with respect to its shareholder investments.

See our latest analysis for Xero

How To Calculate Return On Equity?

ROE 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 Xero is:

7.1% = NZ$36m ÷ NZ$515m (Based on the trailing twelve months to September 2020).

The 'return' refers to a company's earnings over the last year. Another way to think of that is that for every A$1 worth of equity, the company was able to earn A$0.07 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.

A Side By Side comparison of Xero's Earnings Growth And 7.1% ROE

At first glance, Xero's 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 12% either. Despite this, surprisingly, Xero saw an exceptional 54% net income growth over the past five years. Therefore, there could be other reasons behind this growth. Such as - high earnings retention or an efficient management in place.

We then compared Xero's net income growth with the industry and we're pleased to see that the company's growth figure is higher when compared with the industry which has a growth rate of 11% 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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. If you're wondering about Xero's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Xero Using Its Retained Earnings Effectively?

Conclusion

On the whole, we do feel that Xero has some positive attributes. Even in spite of the low rate of return, the company has posted impressive earnings growth as a result of reinvesting heavily into its business. With that said, the latest industry analyst forecasts reveal that the company's earnings growth is expected to slow down. 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. 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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