Most readers would already be aware that Tech Mahindra's (NSE:TECHM) stock increased significantly by 22% over the past three months. Given the company's impressive performance, we decided to study its financial indicators more closely as a company's financial health over the long-term usually dictates market outcomes. Particularly, we will be paying attention to Tech Mahindra'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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
See our latest analysis for Tech Mahindra
How Do You 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 Tech Mahindra is:
16% = ₹39b ÷ ₹241b (Based on the trailing twelve months to September 2020).
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 ₹0.16 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.
Tech Mahindra's Earnings Growth And 16% ROE
At first glance, Tech Mahindra seems to have a decent ROE. On comparing with the average industry ROE of 10% the company's ROE looks pretty remarkable. This certainly adds some context to Tech Mahindra's decent 9.8% net income growth seen over the past five years.
As a next step, we compared Tech Mahindra's net income growth with the industry and were disappointed to see that the company's growth is lower than the industry average growth of 12% in the same period.
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. If you're wondering about Tech Mahindra's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.
Is Tech Mahindra Efficiently Re-investing Its Profits?
Tech Mahindra has a healthy combination of a moderate three-year median payout ratio of 32% (or a retention ratio of 68%) and a respectable amount of growth in earnings as we saw above, meaning that the company has been making efficient use of its profits.
Moreover, Tech Mahindra is determined to keep sharing its profits with shareholders which we infer from its long history of paying a dividend for at least ten years. Our latest analyst data shows that the future payout ratio of the company is expected to rise to 40% over the next three years. Regardless, the future ROE for Tech Mahindra is speculated to rise to 19% despite the anticipated increase in the payout ratio. There could probably be other factors that could be driving the future growth in the ROE.
Conclusion
On the whole, we feel that Tech Mahindra's performance has been quite good. In particular, it's great to see that the company is investing heavily into its business and along with a high rate of return, that has resulted in a respectable growth in its earnings. That being so, the latest analyst forecasts show that the company will continue to see an expansion in its earnings. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page for the company.
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