With its stock down 7.0% over the past three months, it is easy to disregard Timken (NYSE:TKR). But if you pay close attention, you might gather that its strong financials could mean that the stock could potentially see an increase in value in the long-term, given how markets usually reward companies with good financial health. Particularly, we will be paying attention to Timken's 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 Is ROE Calculated?
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 Timken is:
14% = US$324m ÷ US$2.3b (Based on the trailing twelve months to March 2021).
The 'return' is the amount earned after tax over the last twelve months. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.14.
What Has ROE Got To Do With Earnings Growth?
So far, we've learned that ROE is a measure of a company's profitability. 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.
Timken's Earnings Growth And 14% ROE
To start with, Timken's ROE looks acceptable. On comparing with the average industry ROE of 11% the company's ROE looks pretty remarkable. Probably as a result of this, Timken was able to see an impressive net income growth of 21% over the last five years. However, there could also be other causes behind this growth. For example, it is possible that the company's management has made some good strategic decisions, or that the company has a low payout ratio.
As a next step, we compared Timken's net income growth with the industry, and pleasingly, we found that the growth seen by the company is higher than the average industry growth of 8.1%.
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. What is TKR worth today? The intrinsic value infographic in our free research report helps visualize whether TKR is currently mispriced by the market.
Is Timken Efficiently Re-investing Its Profits?
Timken has a three-year median payout ratio of 27% (where it is retaining 73% of its income) which is not too low or not too high. By the looks of it, the dividend is well covered and Timken is reinvesting its profits efficiently as evidenced by its exceptional growth which we discussed above.
Moreover, Timken is determined to keep sharing its profits with shareholders which we infer from its long history of paying a dividend for at least ten years. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 18% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 18%, over the same period.
Overall, we are quite pleased with Timken's performance. In particular, it's great to see that the company is investing heavily into its business and along with a high rate of return, that has resulted in a sizeable growth in its earnings. The latest industry analyst forecasts show that the company is expected to maintain 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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