Grainger plc's (LON:GRI) Fundamentals Look Pretty Strong: Could The Market Be Wrong About The Stock?

It is hard to get excited after looking at Grainger's (LON:GRI) recent performance, when its stock has declined 1.1% over the past three months. However, the company's fundamentals look pretty decent, and long-term financials are usually aligned with future market price movements. Particularly, we will be paying attention to Grainger's 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. Put another way, it reveals the company's success at turning shareholder investments into profits.

View our latest analysis for Grainger

How Do You Calculate Return On Equity?

The formula for return on equity is:

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

So, based on the above formula, the ROE for Grainger is:

6.3% = UK£93m ÷ UK£1.5b (Based on the trailing twelve months to September 2020).

The 'return' is the income the business earned over the last year. That means that for every £1 worth of shareholders' equity, the company generated £0.06 in profit.

What Is The Relationship Between ROE And Earnings Growth?

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

Grainger's Earnings Growth And 6.3% ROE

At first glance, Grainger's ROE doesn't look very promising. However, given that the company's ROE is similar to the average industry ROE of 6.9%, we may spare it some thought. Having said that, Grainger has shown a modest net income growth of 14% over the past five years. Considering the moderately low ROE, it is quite possible that there might be some 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.

Next, on comparing with the industry net income growth, we found that Grainger's growth is quite high when compared to the industry average growth of 0.7% in the same period, which is great to see.

Earnings growth is an important metric to consider when valuing a stock. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. 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 Grainger is trading on a high P/E or a low P/E, relative to its industry.

Is Grainger Efficiently Re-investing Its Profits?

Grainger has a healthy combination of a moderate three-year median payout ratio of 28% (or a retention ratio of 72%) and a respectable amount of growth in earnings as we saw above, meaning that the company has been making efficient use of its profits.

Additionally, Grainger has paid dividends over a period of at least ten years which means that the company is pretty serious about sharing its profits with shareholders. Our latest analyst data shows that the future payout ratio of the company is expected to rise to 64% over the next three years. Accordingly, the expected increase in the payout ratio explains the expected decline in the company's ROE to 4.8%, over the same period.

Summary

In total, it does look like Grainger has some positive aspects to its business. Despite its low rate of return, the fact that the company reinvests a very high portion of its profits into its business, no doubt contributed to its high earnings growth. The latest industry analyst forecasts show that the company is expected to maintain its current growth rate. 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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