Railcare Group AB (publ)'s (STO:RAIL) Stock Has Been Sliding But Fundamentals Look Strong: Is The Market Wrong?

It is hard to get excited after looking at Railcare Group's (STO:RAIL) recent performance, when its stock has declined 4.0% over the past week. However, stock prices are usually driven by a company’s financial performance over the long term, which in this case looks quite promising. Specifically, we decided to study Railcare Group's ROE in this article.

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. 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 Railcare Group

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 Railcare Group is:

22% = kr44m ÷ kr195m (Based on the trailing twelve months to December 2020).

The 'return' refers to a company's earnings over the last year. Another way to think of that is that for every SEK1 worth of equity, the company was able to earn SEK0.22 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 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.

Railcare Group's Earnings Growth And 22% ROE

Firstly, we acknowledge that Railcare Group has a significantly high ROE. Secondly, even when compared to the industry average of 7.9% the company's ROE is quite impressive. Despite this, Railcare Group's five year net income growth was quite low averaging at only 4.4%. This is interesting as the high returns should mean that the company has the ability to generate high growth but for some reason, it hasn't been able to do so. Such a scenario is likely to take place when a company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.

As a next step, we compared Railcare Group's net income growth with the industry, and pleasingly, we found that the growth seen by the company is higher than the average industry growth of 3.0%.

Earnings growth is a huge factor in stock valuation. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. 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 Railcare Group is trading on a high P/E or a low P/E, relative to its industry.

Is Railcare Group Efficiently Re-investing Its Profits?

Despite having a normal three-year median payout ratio of 33% (or a retention ratio of 67% over the past three years, Railcare Group has seen very little growth in earnings as we saw above. So there could be some other explanation in that regard. For instance, the company's business may be deteriorating.

Additionally, Railcare Group 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. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 37% of its profits over the next three years. As a result, Railcare Group's ROE is not expected to change by much either, which we inferred from the analyst estimate of 19% for future ROE.

Conclusion

On the whole, we feel that Railcare Group's performance has been quite good. Specifically, we like that the company is reinvesting a huge chunk of its profits at a high rate of return. This of course has caused the company to see substantial growth in its earnings. If the company continues to grow its earnings the way it has, that could have a positive impact on its share price given how earnings per share influence long-term share prices. Let's not forget, business risk is also one of the factors that affects the price of the stock. So this is also an important area that investors need to pay attention to before making a decision on any business. You can see the 3 risks we have identified for Railcare Group by visiting our risks dashboard for free on our platform here.

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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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