Most readers would already be aware that General Dynamics' (NYSE:GD) stock increased significantly by 20% over the past three months. 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 General Dynamics' ROE in this article.
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. Put another way, it reveals the company's success at turning shareholder investments into profits.
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 General Dynamics is:
20% = US$3.2b ÷ US$16b (Based on the trailing twelve months to December 2020).
The 'return' is the amount earned after tax over the last twelve months. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.20 in profit.
What Is The Relationship Between ROE And Earnings Growth?
Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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. 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.
General Dynamics' Earnings Growth And 20% ROE
To start with, General Dynamics' ROE looks acceptable. On comparing with the average industry ROE of 8.8% the company's ROE looks pretty remarkable. Despite this, General Dynamics' five year net income growth was quite low averaging at only 3.9%. This is generally not the case as when a company has a high rate of return it should usually also have a high earnings growth rate. 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.
We then compared General Dynamics' net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 13% in the same period, which is a bit concerning.
Earnings growth is a huge factor in stock valuation. 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. Is GD fairly valued? This infographic on the company's intrinsic value has everything you need to know.
Is General Dynamics Making Efficient Use Of Its Profits?
Despite having a normal three-year median payout ratio of 35% (or a retention ratio of 65% over the past three years, General Dynamics 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, General Dynamics 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. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to rise to 42% over the next three years. Despite the higher expected payout ratio, the company's ROE is not expected to change by much.
Overall, we feel that General Dynamics certainly does have some positive factors to consider. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE and and a high reinvestment rate. We believe that there might be some outside factors that could be having a negative impact on the business. Having said that, looking at the current analyst estimates, we found that the company's earnings are expected to gain momentum. 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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