The Colonial Motor Company Limited's (NZSE:CMO) Stock Been Rising But Financials Look Weak: Should Shareholders Be Worried?

Colonial Motor's (NZSE:CMO) stock is up by 7.3% over the past three months. However, its weak financial performance indicators makes us a bit doubtful if that trend could continue. In this article, we decided to focus on Colonial Motor's ROE.

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.

Check out our latest analysis for Colonial Motor

How Is ROE Calculated?

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 Colonial Motor is:

10% = NZ$23m ÷ NZ$231m (Based on the trailing twelve months to June 2020).

The 'return' refers to a company's earnings over the last year. 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 Has ROE Got To Do With 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. 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.

Colonial Motor's Earnings Growth And 10% ROE

On the face of it, Colonial Motor's ROE is not much to talk about. A quick further study shows that the company's ROE doesn't compare favorably to the industry average of 13% either. Thus, the low net income growth of 2.2% seen by Colonial Motor over the past five years could probably be the result of the low ROE.

Next, on comparing with the industry net income growth, we found that Colonial Motor's reported growth was lower than the industry growth of 7.3% in the same period, which is not something we like to see.

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. Doing so will help them establish if the stock's future looks promising or ominous. If you're wondering about Colonial Motor's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Colonial Motor Efficiently Re-investing Its Profits?

The high three-year median payout ratio of 64% (that is, the company retains only 36% of its income) over the past three years for Colonial Motor suggests that the company's earnings growth was lower as a result of paying out a majority of its earnings.

Additionally, Colonial Motor 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 Colonial Motor. As a result of its low ROE and lack of mich reinvestment into the business, the company has seen a disappointing earnings growth rate. In brief, we think the company is risky and investors should think twice before making any final judgement on this company. Our risks dashboard would have the 2 risks we have identified for Colonial Motor.

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This article by Simply Wall St is general in nature. 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.
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