The a2 Milk Company Limited (NZSE:ATM) Is Going Strong But Fundamentals Appear To Be Mixed : Is There A Clear Direction For The Stock?

a2 Milk's (NZSE:ATM) stock is up by a considerable 20% over the past three months. However, we wonder if the company's inconsistent financials would have any adverse impact on the current share price momentum. In this article, we decided to focus on a2 Milk's ROE.

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. Put another way, it reveals the company's success at turning shareholder investments into profits.

Check out our latest analysis for a2 Milk

How To 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 a2 Milk is:

9.6% = NZ$115m ÷ NZ$1.2b (Based on the trailing twelve months to June 2022).

The 'return' is the yearly profit. Another way to think of that is that for every NZ$1 worth of equity, the company was able to earn NZ$0.10 in profit.

What Is The Relationship Between ROE And Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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. 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 a2 Milk's Earnings Growth And 9.6% ROE

When you first look at it, a2 Milk's ROE doesn't look that attractive. However, given that the company's ROE is similar to the average industry ROE of 9.0%, we may spare it some thought. But then again, a2 Milk's five year net income shrunk at a rate of 5.2%. Bear in mind, the company does have a slightly low ROE. Therefore, the decline in earnings could also be the result of this.

From the 4.5% decline reported by the industry in the same period, we infer that a2 Milk and its industry are both shrinking at a similar rate.

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 ATM fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is a2 Milk Making Efficient Use Of Its Profits?

a2 Milk doesn't pay any dividend, meaning that the company is keeping all of its profits, which makes us wonder why it is retaining its earnings if it can't use them to grow its business. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.

Conclusion

On the whole, we feel that the performance shown by a2 Milk can be open to many interpretations. While the company does have a high rate of profit retention, its low rate of return is probably hampering its earnings growth. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. 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.