Elco (TLV:ELCO) has had a great run on the share market with its stock up by a significant 10% over the last three months. As most would know, fundamentals are what usually guide market price movements over the long-term, so we decided to look at the company's key financial indicators today to determine if they have any role to play in the recent price movement. Particularly, we will be paying attention to Elco's 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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
How Is ROE Calculated?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Elco is:
14% = US$138m ÷ US$971m (Based on the trailing twelve months to March 2021).
The 'return' is the amount earned after tax over the last twelve months. One way to conceptualize this is that for each ₪1 of shareholders' capital it has, the company made ₪0.14 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. 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.
Elco's Earnings Growth And 14% ROE
To begin with, Elco seems to have a respectable ROE. Even when compared to the industry average of 14% the company's ROE looks quite decent. For this reason, Elco's five year net income decline of 15% raises the question as to why the decent ROE didn't translate into growth. We reckon that there could be some other factors at play here that are preventing the company's growth. For example, it could be that the company has a high payout ratio or the business has allocated capital poorly, for instance.
That being said, we compared Elco's performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 6.8% in the same period.
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. 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 Elco is trading on a high P/E or a low P/E, relative to its industry.
Is Elco Efficiently Re-investing Its Profits?
In spite of a normal three-year median payout ratio of 30% (that is, a retention ratio of 70%), the fact that Elco's earnings have shrunk is quite puzzling. So there could be some other explanations in that regard. For instance, the company's business may be deteriorating.
Moreover, Elco 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.
In total, it does look like Elco has some positive aspects to its business. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE and and a high reinvestment rate. We believe that there might be some outside factors that could be having a negative impact on the business. While we won't completely dismiss the company, what we would do, is try to ascertain how risky the business is to make a more informed decision around the company. You can see the 2 risks we have identified for Elco by visiting our risks dashboard for free on our platform here.
If you’re looking to trade a wide range of investments, open an account with the lowest-cost* platform trusted by professionals, Interactive Brokers. Their clients from over 200 countries and territories trade stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted
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.
*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.