Are Strong Financial Prospects The Force That Is Driving The Momentum In Auto Trader Group plc's LON:AUTO) Stock?

Auto Trader Group (LON:AUTO) has had a great run on the share market with its stock up by a significant 22% over the last three months. Given that the market rewards strong financials in the long-term, we wonder if that is the case in this instance. Particularly, we will be paying attention to Auto Trader Group's ROE today.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. 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 Auto Trader Group

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 Auto Trader Group is:

44% = UK£236m ÷ UK£540m (Based on the trailing twelve months to September 2023).

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 £0.44 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. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. 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 Auto Trader Group's Earnings Growth And 44% ROE

First thing first, we like that Auto Trader Group has an impressive ROE. Second, a comparison with the average ROE reported by the industry of 7.0% also doesn't go unnoticed by us. Probably as a result of this, Auto Trader Group was able to see a decent net income growth of 5.7% over the last five years.

We then performed a comparison between Auto Trader Group's net income growth with the industry, which revealed that the company's growth is similar to the average industry growth of 5.4% in the same 5-year period.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. Doing so will help them establish if the stock's future looks promising or ominous. Is AUTO fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is Auto Trader Group Using Its Retained Earnings Effectively?

With a three-year median payout ratio of 34% (implying that the company retains 66% of its profits), it seems that Auto Trader Group is reinvesting efficiently in a way that it sees respectable amount growth in its earnings and pays a dividend that's well covered.

Besides, Auto Trader Group has been paying dividends over a period of eight years. This shows that the company is committed to sharing profits with its shareholders. 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 32%. Accordingly, forecasts suggest that Auto Trader Group's future ROE will be 50% which is again, similar to the current ROE.

Summary

In total, we are pretty happy with Auto Trader Group's performance. Particularly, we like that the company is reinvesting heavily into its business, and at a high rate of return. Unsurprisingly, this has led to an impressive earnings growth. That being so, the latest analyst forecasts show that the company will continue to see an expansion in its earnings. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page for the company.

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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.