Formula Systems (1985) Ltd.'s (TLV:FORTY) Stock Has Seen Strong Momentum: Does That Call For Deeper Study Of Its Financial Prospects?

Most readers would already be aware that Formula Systems (1985)'s (TLV:FORTY) stock increased significantly by 21% over the past three months. 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. Particularly, we will be paying attention to Formula Systems (1985)'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. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

View our latest analysis for Formula Systems (1985)

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 Formula Systems (1985) is:

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

The 'return' is the yearly profit. That means that for every ₪1 worth of shareholders' equity, the company generated ₪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.

A Side By Side comparison of Formula Systems (1985)'s Earnings Growth And 12% ROE

To begin with, Formula Systems (1985) seems to have a respectable ROE. Yet, the fact that the company's ROE is lower than the industry average of 17% does temper our expectations. Additionally, the flat earnings seen by Formula Systems (1985) over the past five years doesn't paint a very bright picture. Not to forget, the company does have a decent ROE to begin with, just that it is lower than the industry average. So there might be other reasons for the flat earnings growth. Such as, the company pays out a huge portion of its earnings as dividends, or is faced with competitve pressures.

We then compared Formula Systems (1985)'s net income growth with the industry and found that the average industry growth rate was 7.4% in the same period.

Earnings growth is a huge factor in stock valuation. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. This then helps them determine if the stock is placed for a bright or bleak future. Is Formula Systems (1985) fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Formula Systems (1985) Making Efficient Use Of 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.

Conclusion

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 moderate 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. So far, we've only made a quick discussion around the company's earnings growth. To gain further insights into Formula Systems (1985)'s past profit growth, check out this visualization of past earnings, revenue and cash flows.

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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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