AO World plc's (LON:AO.) Stock Is Going Strong: Is the Market Following Fundamentals?

Most readers would already be aware that AO World's (LON:AO.) stock increased significantly by 102% over the past three months. Given the company's impressive performance, we decided to study its financial indicators more closely as a company's financial health over the long-term usually dictates market outcomes. Specifically, we decided to study AO World's ROE in this article.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

See our latest analysis for AO World

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 AO World is:

23% = UK£22m ÷ UK£95m (Based on the trailing twelve months to September 2020).

The 'return' is the income the business earned over the last year. So, this means that for every £1 of its shareholder's investments, the company generates a profit of £0.23.

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. 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.

AO World's Earnings Growth And 23% ROE

Firstly, we acknowledge that AO World has a significantly high ROE. Additionally, a comparison with the average industry ROE of 20% also portrays the company's ROE in a good light. Therefore, it looks like the high ROE is what probably supported AO World's modest 16% growth over the past five years.

As a next step, we compared AO World's net income growth with the industry, and pleasingly, we found that the growth seen by the company is higher than the average industry growth of 11%.

Earnings growth is a huge factor in stock valuation. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. If you're wondering about AO World's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is AO World Making Efficient Use Of Its Profits?

Summary

Overall, we are quite pleased with AO World'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. If the company continues to grow its earnings the way it has, that could have a positive impact on its share price given how earnings per share influence long-term share prices. Remember, the price of a stock is also dependent on the perceived risk. Therefore investors must keep themselves informed about the risks involved before investing in any company. Our risks dashboard will have the 1 risk we have identified for AO World.

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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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