It is hard to get excited after looking at Cummins' (NYSE:CMI) recent performance, when its stock has declined 7.5% over the past three months. However, a closer look at its sound financials might cause you to think again. Given that fundamentals usually drive long-term market outcomes, the company is worth looking at. Particularly, we will be paying attention to Cummins' ROE today.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
How Do You Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Cummins is:
21% = US$1.9b ÷ US$9.0b (Based on the trailing twelve months to April 2021).
The 'return' refers to a company's earnings over the last year. That means that for every $1 worth of shareholders' equity, the company generated $0.21 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. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don’t share these attributes.
Cummins' Earnings Growth And 21% ROE
To start with, Cummins' ROE looks acceptable. On comparing with the average industry ROE of 11% the company's ROE looks pretty remarkable. This certainly adds some context to Cummins' decent 11% net income growth seen over the past five years.
Next, on comparing with the industry net income growth, we found that Cummins' growth is quite high when compared to the industry average growth of 8.0% in the same period, which is great to see.
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 CMI fairly valued? This infographic on the company's intrinsic value has everything you need to know.
Is Cummins Efficiently Re-investing Its Profits?
With a three-year median payout ratio of 39% (implying that the company retains 61% of its profits), it seems that Cummins is reinvesting efficiently in a way that it sees respectable amount growth in its earnings and pays a dividend that's well covered.
Additionally, Cummins has paid dividends over a period of at least ten years which means that the company is pretty serious about sharing its profits with shareholders. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 31% over the next three years. The fact that the company's ROE is expected to rise to 28% over the same period is explained by the drop in the payout ratio.
On the whole, we feel that Cummins' performance has been quite good. Particularly, we like that the company is reinvesting heavily into its business, and at a high rate of return. Unsurprisingly, this has led to an impressive earnings growth. With that said, the latest industry analyst forecasts reveal that the company's earnings growth is expected to slow down. 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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