Has A. O. Smith Corporation's (NYSE:AOS) Impressive Stock Performance Got Anything to Do With Its Fundamentals?

Most readers would already be aware that A. O. Smith's (NYSE:AOS) stock increased significantly by 14% over the past 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 A. O. Smith's ROE in this article.

ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. 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 A. O. Smith

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 A. O. Smith is:

30% = US$577m ÷ US$1.9b (Based on the trailing twelve months to June 2024).

The 'return' is the income the business earned over the last year. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.30.

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 A. O. Smith's Earnings Growth And 30% ROE

First thing first, we like that A. O. Smith has an impressive ROE. Secondly, even when compared to the industry average of 19% the company's ROE is quite impressive. Yet, A. O. Smith has posted measly growth of 5.0% over the past five years. 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 A. O. Smith's net income growth with the industry and were disappointed to see that the company's growth is lower than the industry average growth of 18% 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. Is AOS fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is A. O. Smith Using Its Retained Earnings Effectively?

Despite having a normal three-year median payout ratio of 35% (or a retention ratio of 65% over the past three years, A. O. Smith has seen very little growth in earnings as we saw above. Therefore, there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.

Moreover, A. O. Smith has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over earnings growth. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 28% over the next three years. Regardless, the ROE is not expected to change much for the company despite the lower expected payout ratio.

Conclusion

In total, it does look like A. O. Smith has some positive aspects to its business. Yet, the low earnings growth is a bit concerning, especially given that the company has a high rate of return and is reinvesting ma huge portion of its profits. By the looks of it, there could be some other factors, not necessarily in control of the business, that's preventing growth. We also studied the latest analyst forecasts and found that the company's earnings growth is expected be similar to its current growth rate. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page for the company.

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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.