easyJet (LON:EZJ) has had a great run on the share market with its stock up by a significant 62% over the last month. We wonder if and what role the company's financials play in that price change as a company's long-term fundamentals usually dictate market outcomes. Specifically, we decided to study easyJet's ROE in this article.
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 other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
How To Calculate Return On Equity?
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 easyJet is:
12% = UK£243m ÷ UK£2.1b (Based on the trailing twelve months to March 2020).
The 'return' is the profit 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 £0.12 in profit.
Why Is ROE Important For 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.
easyJet's Earnings Growth And 12% ROE
To begin with, easyJet seems to have a respectable ROE. Even when compared to the industry average of 11% the company's ROE looks quite decent. As you might expect, the 15% net income decline reported by easyJet is a bit of a surprise. We reckon that there could be some other factors at play here that are preventing the company's growth. Such as, the company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.
Next, when we compared with the industry, which has shrunk its earnings at a rate of 0.9% in the same period, we still found easyJet's performance to be quite bleak, because the company has been shrinking its earnings faster than the industry.
Earnings growth is an important metric to consider when valuing a stock. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). This then helps them determine if the stock is placed for a bright or bleak future. Is EZJ fairly valued? This infographic on the company's intrinsic value has everything you need to know.
Is easyJet Efficiently Re-investing Its Profits?
easyJet's declining earnings is not surprising given how the company is spending most of its profits in paying dividends, judging by its three-year median payout ratio of 64% (or a retention ratio of 36%). With only a little being reinvested into the business, earnings growth would obviously be low or non-existent. To know the 5 risks we have identified for easyJet visit our risks dashboard for free.
In addition, easyJet has been paying dividends over a period of nine years suggesting that keeping up dividend payments is preferred by the management even though earnings have been in decline. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 42% over the next three years. The fact that the company's ROE is expected to rise to 15% over the same period is explained by the drop in the payout ratio.
Overall, we feel that easyJet certainly does have some positive factors to consider. However, while the company does have a high ROE, its earnings growth number is quite disappointing. This can be blamed on the fact that it reinvests only a small portion of its profits and pays out the rest as dividends. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. 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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