Could Kao Corporation's (TSE:4452) Weak Financials Mean That The Market Could Correct Its Share Price?

Kao's (TSE:4452) stock up by 3.1% over the past three months. However, in this article, we decided to focus on its weak financials, as long-term fundamentals ultimately dictate market outcomes. Particularly, we will be paying attention to Kao'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 other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

See our latest analysis for Kao

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 Kao is:

6.7% = JP¥73b ÷ JP¥1.1t (Based on the trailing twelve months to June 2024).

The 'return' is the amount earned after tax over the last twelve months. So, this means that for every ¥1 of its shareholder's investments, the company generates a profit of ¥0.07.

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. 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.

Kao's Earnings Growth And 6.7% ROE

On the face of it, Kao's ROE is not much to talk about. Next, when compared to the average industry ROE of 8.5%, the company's ROE leaves us feeling even less enthusiastic. For this reason, Kao's five year net income decline of 21% is not surprising given its lower ROE. We believe that there also might be other aspects that are negatively influencing the company's earnings prospects. For example, it is possible that the business has allocated capital poorly or that the company has a very high payout ratio.

However, when we compared Kao's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 5.0% in the same period. This is quite worrisome.

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). Doing so will help them establish if the stock's future looks promising or ominous. Is Kao fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Kao Making Efficient Use Of Its Profits?

With a high three-year median payout ratio of 80% (implying that 20% of the profits are retained), most of Kao's profits are being paid to shareholders, which explains the company's shrinking earnings. With only very little left to reinvest into the business, growth in earnings is far from likely. You can see the 2 risks we have identified for Kao by visiting our risks dashboard for free on our platform here.

Additionally, Kao has paid dividends over a period of at least ten years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth.

Summary

Overall, we would be extremely cautious before making any decision on Kao. As a result of its low ROE and lack of much reinvestment into the business, the company has seen a disappointing earnings growth rate. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. 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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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.