Linamar Corporation's (TSE:LNR) Financials Are Too Obscure To Link With Current Share Price Momentum: What's In Store For the Stock?

Linamar (TSE:LNR) has had a great run on the share market with its stock up by a significant 19% over the last three months. But the company's key financial indicators appear to be differing across the board and that makes us question whether or not the company's current share price momentum can be maintained. Particularly, we will be paying attention to Linamar's ROE today.

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

View our latest analysis for Linamar

How To 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 Linamar is:

5.1% = CA$216m ÷ CA$4.2b (Based on the trailing twelve months to September 2020).

The 'return' is the profit over the last twelve months. One way to conceptualize this is that for each CA$1 of shareholders' capital it has, the company made CA$0.05 in profit.

Why Is ROE Important For Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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. 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.

A Side By Side comparison of Linamar's Earnings Growth And 5.1% ROE

When you first look at it, Linamar's ROE doesn't look that attractive. A quick further study shows that the company's ROE doesn't compare favorably to the industry average of 13% either. For this reason, Linamar's five year net income decline of 5.1% is not surprising given its lower ROE. We reckon that there could also be other factors at play here. For example, it is possible that the business has allocated capital poorly or that the company has a very high payout ratio.

We then compared Linamar's performance with the industry and found that the company has shrunk its earnings at a slower rate than the industry earnings which has seen its earnings shrink by 8.4% in the same period. This does offer shareholders some relief

Earnings growth is an important metric to consider when valuing a stock. 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. If you're wondering about Linamar's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Linamar Efficiently Re-investing Its Profits?

Linamar's low three-year median payout ratio of 6.0% (or a retention ratio of 94%) over the last three years should mean that the company is retaining most of its earnings to fuel its growth but the company's earnings have actually shrunk. This typically shouldn't be the case when a company is retaining most of its earnings. So there could be some other explanations in that regard. For example, the company's business may be deteriorating.

In addition, Linamar has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Based on the latest analysts' estimates, we found that the company's future payout ratio over the next three years is expected to hold steady at 6.8%.

Summary

In total, we're a bit ambivalent about Linamar's performance. 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. Wrapping up, we would proceed with caution with this company and one way of doing that would be to look at the risk profile of the business. Our risks dashboard would have the 2 risks we have identified for Linamar.

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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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