Declining Stock and Decent Financials: Is The Market Wrong About Tesco PLC (LON:TSCO)?

Tesco (LON:TSCO) has had a rough month with its share price down 29%. But if you pay close attention, you might find that its key financial indicators look quite decent, which could mean that the stock could potentially rise in the long-term given how markets usually reward more resilient long-term fundamentals. Specifically, we decided to study Tesco's ROE in this article.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

Check out our latest analysis for Tesco

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 Tesco is:

8.5% = UK£1.0b ÷ UK£12b (Based on the trailing twelve months to August 2020).

The 'return' is the amount earned after tax over the last twelve months. That means that for every £1 worth of shareholders' equity, the company generated £0.09 in profit.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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 everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.

A Side By Side comparison of Tesco's Earnings Growth And 8.5% ROE

On the face of it, Tesco's ROE is not much to talk about. A quick further study shows that the company's ROE doesn't compare favorably to the industry average of 18% either. However, we we're pleasantly surprised to see that Tesco grew its net income at a significant rate of 64% in the last five years. So, there might be other aspects that are positively influencing the company's earnings growth. For example, it is possible that the company's management has made some good strategic decisions, or that the company has a low payout ratio.

As a next step, we compared Tesco's net income growth with the industry, and pleasingly, we found that the growth seen by the company is higher than the average industry growth of 17%.

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. This then helps them determine if the stock is placed for a bright or bleak future. Is Tesco fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Tesco Making Efficient Use Of Its Profits?

The three-year median payout ratio for Tesco is 44%, which is moderately low. The company is retaining the remaining 56%. By the looks of it, the dividend is well covered and Tesco is reinvesting its profits efficiently as evidenced by its exceptional growth which we discussed above.

Besides, Tesco has been paying dividends for at least ten years or more. This shows that the company is committed to sharing profits with its shareholders. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to rise to 53% over the next three years. However, Tesco's future ROE is expected to rise to 10% despite the expected increase in the company's payout ratio. We infer that there could be other factors that could be driving the anticipated growth in the company's ROE.

Summary

In total, it does look like Tesco has some positive aspects to its business. With a high rate of reinvestment, albeit at a low ROE, the company has managed to see a considerable growth in its earnings. That being so, a study of the latest analyst forecasts show that the company is expected to see a slowdown in its future earnings growth. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.

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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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