The a2 Milk Company Limited's (NZSE:ATM) Stock On An Uptrend: Could Fundamentals Be Driving The Momentum?

a2 Milk's (NZSE:ATM) stock is up by a considerable 39% over the past three months. As most would know, fundamentals are what usually guide market price movements over the long-term, so we decided to look at the company's key financial indicators today to determine if they have any role to play in the recent price movement. In this article, we decided to focus on a2 Milk's ROE.

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.

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 a2 Milk is:

12% = NZ$159m ÷ NZ$1.4b (Based on the trailing twelve months to December 2024).

The 'return' is the yearly profit. That means that for every NZ$1 worth of shareholders' equity, the company generated NZ$0.12 in profit.

See our latest analysis for a2 Milk

What Has ROE Got To Do With Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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.

A Side By Side comparison of a2 Milk's Earnings Growth And 12% ROE

To begin with, a2 Milk seems to have a respectable ROE. Further, the company's ROE is similar to the industry average of 12%. For this reason, a2 Milk's five year net income decline of 18% raises the question as to why the decent ROE didn't translate into growth. So, there might be some other aspects that could explain this. Such as, the company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.

Next, when we compared with the industry, which has shrunk its earnings at a rate of 7.3% in the same 5-year period, we still found a2 Milk's performance to be quite bleak, because the company has been shrinking its earnings faster than the industry.

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 a2 Milk is trading on a high P/E or a low P/E, relative to its industry.

Is a2 Milk Making Efficient Use Of Its Profits?

Looking at its three-year median payout ratio of 27% (or a retention ratio of 73%) which is pretty normal, a2 Milk's declining earnings is rather baffling as one would expect to see a fair bit of growth when a company is retaining a good portion of its profits. It looks like there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.

Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to rise to 70% over the next three years. Regardless, the future ROE for a2 Milk is speculated to rise to 18% despite the anticipated increase in the payout ratio. There could probably be other factors that could be driving the future growth in the ROE.

Summary

In total, it does look like a2 Milk has some positive aspects to its business. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE and and a high reinvestment rate. We believe that there might be some outside factors that could be having a negative impact on the business. That being so, the latest industry analyst forecasts show that the analysts are expecting to see a huge improvement in the company's earnings growth rate. 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.