Associated British Foods plc's (LON:ABF) Stock Is Rallying But Financials Look Ambiguous: Will The Momentum Continue?

Associated British Foods' (LON:ABF) stock is up by a considerable 20% over the past three months. However, we decided to pay attention to the company's fundamentals which don't appear to give a clear sign about the company's financial health. Particularly, we will be paying attention to Associated British Foods' ROE today.

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. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

View our latest analysis for Associated British Foods

How To Calculate Return On Equity?

The formula for ROE is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Associated British Foods is:

6.2% = UK£720m ÷ UK£12b (Based on the trailing twelve months to September 2022).

The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each £1 of shareholders' capital it has, the company made £0.06 in profit.

Why Is ROE Important For Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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 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.

Associated British Foods' Earnings Growth And 6.2% ROE

When you first look at it, Associated British Foods' ROE doesn't look that attractive. Yet, a closer study shows that the company's ROE is similar to the industry average of 7.5%. But Associated British Foods saw a five year net income decline of 16% over the past five years. Remember, the company's ROE is a bit low to begin with. Therefore, the decline in earnings could also be the result of this.

So, as a next step, we compared Associated British Foods' performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 11% in the same period.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. What is ABF worth today? The intrinsic value infographic in our free research report helps visualize whether ABF is currently mispriced by the market.

Is Associated British Foods Making Efficient Use Of Its Profits?

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. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.

Moreover, Associated British Foods has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over earnings growth. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 35%. Still, forecasts suggest that Associated British Foods' future ROE will rise to 9.9% even though the the company's payout ratio is not expected to change by much.

Conclusion

On the whole, we feel that the performance shown by Associated British Foods can be open to many interpretations. While the company does have a high rate of reinvestment, the low ROE means that all that reinvestment is not reaping any benefit to its investors, and moreover, its having a negative impact on the earnings growth. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. 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. 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.