Has Taiwan Semiconductor Co., Ltd.'s (GTSM:5425) Impressive Stock Performance Got Anything to Do With Its Fundamentals?

Taiwan Semiconductor (GTSM:5425) has had a great run on the share market with its stock up by a significant 8.1% over the last month. We wonder if and what role the company's financials play in that price change as a company's long-term fundamentals usually dictate market outcomes. Specifically, we decided to study Taiwan Semiconductor's ROE in this article.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

View our latest analysis for Taiwan Semiconductor

How To Calculate Return On Equity?

Return on equity 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 Taiwan Semiconductor is:

12% = NT$906m ÷ NT$7.3b (Based on the trailing twelve months to September 2020).

The 'return' is the yearly profit. One way to conceptualize this is that for each NT$1 of shareholders' capital it has, the company made NT$0.12 in profit.

What Is The Relationship Between ROE And Earnings Growth?

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

A Side By Side comparison of Taiwan Semiconductor's Earnings Growth And 12% ROE

To begin with, Taiwan Semiconductor seems to have a respectable ROE. And on comparing with the industry, we found that the the average industry ROE is similar at 11%. However, while Taiwan Semiconductor has a pretty respectable ROE, its five year net income decline rate was 7.5% . Based on this, we feel that there might be other reasons which haven't been discussed so far in this article that could be hampering the company's growth. These include low earnings retention or poor allocation of capital.

So, as a next step, we compared Taiwan Semiconductor'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 8.9% in the same period.

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

Is Taiwan Semiconductor Using Its Retained Earnings Effectively?

With a high three-year median payout ratio of 75% (implying that 25% of the profits are retained), most of Taiwan Semiconductor's profits are being paid to shareholders, which explains the company's shrinking earnings. With only very little left to reinvest into the business, growth in earnings is far from likely. You can see the 2 risks we have identified for Taiwan Semiconductor by visiting our risks dashboard for free on our platform here.

Additionally, Taiwan Semiconductor has paid dividends over a period of eight years, which means that the company's management is rather focused on keeping up its dividend payments, regardless of the shrinking earnings.

Conclusion

On the whole, we do feel that Taiwan Semiconductor has some positive attributes. Yet, the low earnings growth is a bit concerning, especially given that the company has a high rate of return. Investors could have benefitted from the high ROE, had the company been reinvesting more of its earnings. As discussed earlier, the company is retaining a small portion of its profits. 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. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.

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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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