Are Associated British Foods plc's (LON:ABF) Mixed Financials The Reason For Its Gloomy Performance on The Stock Market?

By
Simply Wall St
Published
May 12, 2022
LSE:ABF
Source: Shutterstock

With its stock down 17% over the past three months, it is easy to disregard Associated British Foods (LON:ABF). We, however decided to study the company's financials to determine if they have got anything to do with the price decline. Fundamentals usually dictate market outcomes so it makes sense to study the company's financials. Specifically, we decided to study Associated British Foods' 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 other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

Check out our latest analysis for Associated British Foods

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 Associated British Foods is:

7.8% = UK£810m ÷ UK£10b (Based on the trailing twelve months to March 2022).

The 'return' refers to a company's earnings over the last year. So, this means that for every £1 of its shareholder's investments, the company generates a profit of £0.08.

What Is The Relationship Between ROE And 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. 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.

Associated British Foods' Earnings Growth And 7.8% ROE

When you first look at it, Associated British Foods' 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 11% either. For this reason, Associated British Foods' five year net income decline of 20% is not surprising given its lower ROE. We believe that there also might be other aspects that are negatively influencing the company's earnings prospects. For example, it is possible that the business has allocated capital poorly or that the company has a very high payout ratio.

However, when we compared Associated British Foods' growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 2.4% in the same period. This is quite worrisome.

past-earnings-growth
LSE:ABF Past Earnings Growth May 12th 2022

Earnings growth is a huge factor in stock valuation. 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. Is ABF fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is Associated British Foods Using Its Retained Earnings Effectively?

In spite of a normal three-year median payout ratio of 38% (that is, a retention ratio of 62%), the fact that Associated British Foods' earnings have shrunk is quite puzzling. It looks like there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.

Additionally, Associated British Foods has paid dividends over a period of at least ten years, which means that the company's management is determined to pay dividends even if it means little to no earnings 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 36%. Still, forecasts suggest that Associated British Foods' future ROE will rise to 11% even though the the company's payout ratio is not expected to change by much.

Summary

On the whole, we feel that the performance shown by Associated British Foods can be open to many interpretations. 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. 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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