Has Xero Limited's (ASX:XRO) Impressive Stock Performance Got Anything to Do With Its Fundamentals?

Xero (ASX:XRO) has had a great run on the share market with its stock up by a significant 16% over the last three months. We wonder if and what role the company's financials play in that price change as a company's long-term fundamentals usually dictate market outcomes. Specifically, we decided to study Xero's ROE in this article.

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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

See our latest analysis for Xero

How Is ROE Calculated?

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:

13% = NZ$175m ÷ NZ$1.4b (Based on the trailing twelve months to March 2024).

The 'return' is the income the business earned over the last year. So, this means that for every A$1 of its shareholder's investments, the company generates a profit of A$0.13.

Why Is ROE Important For Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don’t share these attributes.

Xero's Earnings Growth And 13% ROE

To start with, Xero's ROE looks acceptable. And on comparing with the industry, we found that the the average industry ROE is similar at 11%. Despite the modest returns, Xero's five year net income growth was quite low, averaging at only 3.2%. We reckon that a low growth, when returns are moderate could be the result of certain circumstances like low earnings retention or poor allocation of capital.

Next, on comparing with the industry net income growth, we found that Xero's reported growth was lower than the industry growth of 25% over the last few years, which is not something we like to see.

Earnings growth is an important metric to consider when valuing a stock. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. This then helps them determine if the stock is placed for a bright or bleak future. Has the market priced in the future outlook for XRO? You can find out in our latest intrinsic value infographic research report.

Is Xero Efficiently Re-investing Its Profits?

Xero doesn't pay any regular dividends currently which essentially means that it has been reinvesting all of its profits into the business. This doesn't explain the low earnings growth number that we discussed above. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.

Conclusion

On the whole, we do feel that Xero has some positive attributes. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE and and a high reinvestment rate. We believe that there might be some outside factors that could be having a negative impact on the business. Having said that, looking at the current analyst estimates, we found that the company's earnings are expected to gain momentum. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com