Headsent (STO:HEAD) has had a rough month with its share price down 14%. We decided to study the company's financials to determine if the downtrend will continue as the long-term performance of a company usually dictates market outcomes. Particularly, we will be paying attention to Headsent's ROE today.
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
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 Headsent is:
8.0% = kr5.8m ÷ kr73m (Based on the trailing twelve months to September 2021).
The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each SEK1 of shareholders' capital it has, the company made SEK0.08 in profit.
Why Is ROE Important For Earnings Growth?
So far, we've learned that ROE is a measure of a company's profitability. Depending on how much of these profits the company reinvests or "retains", and how effectively it does so, we are then able to assess a company’s earnings growth potential. Assuming everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.
Headsent's Earnings Growth And 8.0% ROE
At first glance, Headsent's ROE doesn't look very promising. We then compared the company's ROE to the broader industry and were disappointed to see that the ROE is lower than the industry average of 18%. Therefore, it might not be wrong to say that the five year net income decline of 43% seen by Headsent was probably the result of it having a lower ROE. However, there could also be other factors causing the earnings to decline. Such as - low earnings retention or poor allocation of capital.
That being said, we compared Headsent's performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 3.8% in the same period.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. Doing so will help them establish if the stock's future looks promising or ominous. If you're wondering about Headsent's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.
Is Headsent Using Its Retained Earnings Effectively?
With a high three-year median payout ratio of 71% (implying that 29% of the profits are retained), most of Headsent's profits are being paid to shareholders, which explains the company's shrinking earnings. The business is only left with a small pool of capital to reinvest - A vicious cycle that doesn't benefit the company in the long-run. You can see the 4 risks we have identified for Headsent by visiting our risks dashboard for free on our platform here.
Moreover, Headsent has been paying dividends for six years, which is a considerable amount of time, suggesting that management must have perceived that the shareholders prefer consistent dividends even though earnings have been shrinking.
On the whole, Headsent's performance is quite a big let-down. As a result of its low ROE and lack of much reinvestment into the business, the company has seen a disappointing earnings growth rate. Until now, we have only just grazed the surface of the company's past performance by looking at the company's fundamentals. So it may be worth checking this free detailed graph of Headsent's past earnings, as well as revenue and cash flows to get a deeper insight into the company's performance.
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.