Is Weakness In Erie Indemnity Company (NASDAQ:ERIE) Stock A Sign That The Market Could be Wrong Given Its Strong Financial Prospects?

It is hard to get excited after looking at Erie Indemnity's (NASDAQ:ERIE) recent performance, when its stock has declined 11% over the past month. 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. In this article, we decided to focus on Erie Indemnity's ROE.

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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.

See our latest analysis for Erie Indemnity

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 Erie Indemnity is:

25% = US$293m ÷ US$1.2b (Based on the trailing twelve months to December 2020).

The 'return' is the yearly profit. That means that for every $1 worth of shareholders' equity, the company generated $0.25 in profit.

What Has ROE Got To Do With Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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. 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.

Erie Indemnity's Earnings Growth And 25% ROE

To begin with, Erie Indemnity has a pretty high ROE which is interesting. Secondly, even when compared to the industry average of 9.0% the company's ROE is quite impressive. Probably as a result of this, Erie Indemnity was able to see a decent net income growth of 12% over the last five years.

As a next step, we compared Erie Indemnity'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 6.6%.

Earnings growth is a huge factor in stock valuation. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. One good indicator of expected earnings growth is the P/E ratio which determines the price the market is willing to pay for a stock based on its earnings prospects. So, you may want to check if Erie Indemnity is trading on a high P/E or a low P/E, relative to its industry.

Is Erie Indemnity Efficiently Re-investing Its Profits?

Erie Indemnity has a significant three-year median payout ratio of 67%, meaning that it is left with only 33% to reinvest into its business. This implies that the company has been able to achieve decent earnings growth despite returning most of its profits to shareholders.

Additionally, Erie Indemnity 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 is expected to keep paying out approximately 73% of its profits over the next three years.

Summary

Overall, we are quite pleased with Erie Indemnity's performance. Especially the high ROE, Which has contributed to the impressive growth seen in earnings. Despite the company reinvesting only a small portion of its profits, it still has managed to grow its earnings so that is appreciable. That being so, a study of the latest analyst forecasts show that the company is expected to see a slowdown in its future earnings growth. 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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