PZ Cussons Plc's (LON:PZC) Stock's Been Going Strong: Could Weak Financials Mean The Market Will Correct Its Share Price?

PZ Cussons (LON:PZC) has had a great run on the share market with its stock up by a significant 16% over the last three months. However, in this article, we decided to focus on its weak fundamentals, as long-term financial performance of a business is what ultimatley dictates market outcomes. Particularly, we will be paying attention to PZ Cussons' ROE today.

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

See our latest analysis for PZ Cussons

How Do You 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 PZ Cussons is:

4.2% = UK£17m ÷ UK£410m (Based on the trailing twelve months to November 2020).

The 'return' is the amount earned after tax over the last twelve months. Another way to think of that is that for every £1 worth of equity, the company was able to earn £0.04 in profit.

What Has ROE Got To Do With 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. 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.

PZ Cussons' Earnings Growth And 4.2% ROE

On the face of it, PZ Cussons' 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 14% either. For this reason, PZ Cussons' five year net income decline of 19% is not surprising given its lower ROE. We reckon that there could also be other factors at play here. Such as - low earnings retention or poor allocation of capital.

However, when we compared PZ Cussons' growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 7.1% in the same period. This is quite worrisome.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. This then helps them determine if the stock is placed for a bright or bleak future. One good indicator of expected earnings growth is the P/E ratio which determines the price the market is willing to pay for a stock based on its earnings prospects. So, you may want to check if PZ Cussons is trading on a high P/E or a low P/E, relative to its industry.

Is PZ Cussons Making Efficient Use Of Its Profits?

With a high three-year median payout ratio of 89% (implying that 11% of the profits are retained), most of PZ Cussons' profits are being paid to shareholders, which explains the company's shrinking earnings. With only very little left to reinvest into the business, growth in earnings is far from likely. To know the 3 risks we have identified for PZ Cussons visit our risks dashboard for free.

Moreover, PZ Cussons 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. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 48% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 12%, over the same period.

Conclusion

Overall, we would be extremely cautious before making any decision on PZ Cussons. As a result of its low ROE and lack of mich reinvestment into the business, the company has seen a disappointing earnings growth rate. 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 latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.

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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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