The a2 Milk Company Limited's (NZSE:ATM) Stock Has Shown A Decent Performance: Have Financials A Role To Play?

Most readers would already know that a2 Milk's (NZSE:ATM) stock increased by 2.8% over the past three months. Given that stock prices are usually aligned with a company's financial performance in the long-term, we decided to investigate if the company's decent financials had a hand to play in the recent price move. Particularly, we will be paying attention to a2 Milk's ROE today.

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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

Check out our latest analysis for a2 Milk

How Is ROE Calculated?

The formula for ROE is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for a2 Milk is:

12% = NZ$154m ÷ NZ$1.3b (Based on the trailing twelve months to June 2024).

The 'return' is the profit over the last twelve months. Another way to think of that is that for every NZ$1 worth of equity, the company was able to earn NZ$0.12 in profit.

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. 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.

a2 Milk's Earnings Growth And 12% ROE

To begin with, a2 Milk seems to have a respectable ROE. And on comparing with the industry, we found that the the average industry ROE is similar at 12%. For this reason, a2 Milk's five year net income decline of 22% raises the question as to why the decent ROE didn't translate into growth. We reckon that there could be some other factors at play here that are preventing the company's growth. These include low earnings retention or poor allocation of capital.

So, as a next step, we compared a2 Milk's performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 0.8% over the last few years.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. 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 a2 Milk is trading on a high P/E or a low P/E, relative to its industry.

Is a2 Milk Efficiently Re-investing Its Profits?

a2 Milk doesn't pay any regular dividends, 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 could be some other explanations in that regard. For instance, the company's business may be deteriorating.

Conclusion

In total, it does look like a2 Milk has some positive aspects to its business. However, given the high ROE and high profit retention, we would expect the company to be delivering strong earnings growth, but that isn't the case here. This suggests that there might be some external threat to the business, that's hampering its 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. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.