With its stock down 10% over the past week, it is easy to disregard Ambika Cotton Mills (NSE:AMBIKCO). However, stock prices are usually driven by a company’s financial performance over the long term, which in this case looks quite promising. In this article, we decided to focus on Ambika Cotton Mills' ROE.
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.
How To 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 Ambika Cotton Mills is:
20% = ₹1.3b ÷ ₹6.5b (Based on the trailing twelve months to September 2021).
The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each ₹1 of shareholders' capital it has, the company made ₹0.20 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. 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 all else is equal, companies that have both a higher return on equity and higher profit retention are usually the ones that have a higher growth rate when compared to companies that don't have the same features.
Ambika Cotton Mills' Earnings Growth And 20% ROE
To start with, Ambika Cotton Mills' ROE looks acceptable. Further, the company's ROE compares quite favorably to the industry average of 11%. This certainly adds some context to Ambika Cotton Mills' decent 7.6% net income growth seen over the past five years.
As a next step, we compared Ambika Cotton Mills' net income growth with the industry and found that the company has a similar growth figure when compared with the industry average growth rate of 8.3% in the same period.
Earnings growth is an important metric to consider when valuing a stock. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. Doing so will help them establish if the stock's future looks promising or ominous. 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 Ambika Cotton Mills is trading on a high P/E or a low P/E, relative to its industry.
Is Ambika Cotton Mills Efficiently Re-investing Its Profits?
Ambika Cotton Mills has a low three-year median payout ratio of 22%, meaning that the company retains the remaining 78% of its profits. This suggests that the management is reinvesting most of the profits to grow the business.
Additionally, Ambika Cotton Mills has paid dividends over a period of at least ten years which means that the company is pretty serious about sharing its profits with shareholders.
Overall, we are quite pleased with Ambika Cotton Mills' performance. Specifically, we like that the company is reinvesting a huge chunk of its profits at a high rate of return. This of course has caused the company to see substantial growth in its earnings. 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. Let's not forget, business risk is also one of the factors that affects the price of the stock. So this is also an important area that investors need to pay attention to before making a decision on any business. You can see the 1 risk we have identified for Ambika Cotton Mills by visiting our risks dashboard for free on our platform here.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.