Formula Systems (1985) Ltd. (TLV:FORTY) Stock's Been Sliding But Fundamentals Look Decent: Will The Market Correct The Share Price In The Future?

Formula Systems (1985) (TLV:FORTY) has had a rough three months with its share price down 12%. However, stock prices are usually driven by a company’s financials over the long term, which in this case look pretty respectable. Particularly, we will be paying attention to Formula Systems (1985)'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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.

See our latest analysis for Formula Systems (1985)

How To Calculate Return On Equity?

Return on equity 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 Formula Systems (1985) is:

12% = US$109m ÷ US$938m (Based on the trailing twelve months to September 2020).

The 'return' is the yearly profit. Another way to think of that is that for every ₪1 worth of equity, the company was able to earn ₪0.12 in profit.

What Is The Relationship Between ROE And Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. Depending on how much of these profits the company reinvests or "retains", and how effectively it does so, we are then able to assess a company’s earnings growth potential. 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.

Formula Systems (1985)'s Earnings Growth And 12% ROE

To begin with, Formula Systems (1985) seems to have a respectable ROE. And on comparing with the industry, we found that the the average industry ROE is similar at 14%. Given the circumstances, we can't help but wonder why Formula Systems (1985) saw little to no growth in the past five years. So, there could be some other aspects that could potentially be preventing the company from growing. These include low earnings retention or poor allocation of capital.

Next, on comparing with the industry net income growth, we found that the industry grew its earnings by5.0% in the same period.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). 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 Formula Systems (1985) is trading on a high P/E or a low P/E, relative to its industry.

Is Formula Systems (1985) Efficiently Re-investing Its Profits?

Despite having a normal three-year median payout ratio of 37% (implying that the company keeps 63% of its income) over the last three years, Formula Systems (1985) has seen a negligible amount of growth in earnings as we saw above. So there could be some other explanation in that regard. For instance, the company's business may be deteriorating.

Moreover, Formula Systems (1985) 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.

Summary

In total, it does look like Formula Systems (1985) 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. Up till now, we've only made a short study of the company's growth data. So it may be worth checking this free detailed graph of Formula Systems (1985)'s past earnings, as well as revenue and cash flows to get a deeper insight into the company's performance.

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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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