It is hard to get excited after looking at Lear's (NYSE:LEA) recent performance, when its stock has declined 9.3% over the past three months. We, however decided to study the company's financials to determine if they have got anything to do with the price decline. Fundamentals usually dictate market outcomes so it makes sense to study the company's financials. Specifically, we decided to study Lear'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.
How Is ROE Calculated?
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 Lear is:
7.9% = US$376m ÷ US$4.7b (Based on the trailing twelve months to April 2021).
The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.08 in profit.
Why Is ROE Important For Earnings Growth?
We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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.
A Side By Side comparison of Lear's Earnings Growth And 7.9% ROE
When you first look at it, Lear's ROE doesn't look that attractive. A quick further study shows that the company's ROE doesn't compare favorably to the industry average of 12% either. For this reason, Lear's five year net income decline of 19% is not surprising given its lower ROE. However, there could also be other factors causing the earnings to decline. Such as - low earnings retention or poor allocation of capital.
So, as a next step, we compared Lear'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 6.2% 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. Doing so will help them establish if the stock's future looks promising or ominous. Has the market priced in the future outlook for LEA? You can find out in our latest intrinsic value infographic research report.
Is Lear Efficiently Re-investing Its Profits?
Lear's low three-year median payout ratio of 21% (or a retention ratio of 79%) over the last three years should mean that the company is retaining most of its earnings to fuel its growth but the company's earnings have actually shrunk. The low payout should mean that the company is retaining most of its earnings and consequently, should see some growth. So there could be some other explanations in that regard. For example, the company's business may be deteriorating.
Additionally, Lear 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. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 7.3% over the next three years. The fact that the company's ROE is expected to rise to 20% over the same period is explained by the drop in the payout ratio.
On the whole, we feel that the performance shown by Lear can be open to many interpretations. Even though it appears to be retaining most of its profits, given the low ROE, investors may not be benefitting from all that reinvestment after all. The low earnings growth suggests our theory correct. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.
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