Most readers would already be aware that American Financial Group's (NYSE:AFG) stock increased significantly by 24% over the past three months. As most would know, fundamentals are what usually guide market price movements over the long-term, so we decided to look at the company's key financial indicators today to determine if they have any role to play in the recent price movement. In this article, we decided to focus on American Financial Group'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 other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
How To Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for American Financial Group is:
11% = US$721m ÷ US$6.8b (Based on the trailing twelve months to December 2020).
The 'return' is the yearly profit. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.11 in profit.
Why Is ROE Important For 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 all else is equal, companies that have both a higher return on equity and higher profit retention are usually the ones that have a higher growth rate when compared to companies that don't have the same features.
American Financial Group's Earnings Growth And 11% ROE
At first glance, American Financial Group seems to have a decent ROE. And on comparing with the industry, we found that the the average industry ROE is similar at 8.9%. Given the circumstances, we can't help but wonder why American Financial Group saw little to no growth in the past five years. So, there could be some other aspects that could potentially be preventing the company from growing. For example, it could be that the company has a high payout ratio or the business has allocated capital poorly, for instance.
As a next step, we compared American Financial Group'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 5.8% 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 AFG fairly valued? This infographic on the company's intrinsic value has everything you need to know.
Is American Financial Group Making Efficient Use Of Its Profits?
American Financial Group's low three-year median payout ratio of 23% (implying that the company keeps77% of its income) should mean that the company is retaining most of its earnings to fuel its growth and this should be reflected in its growth number, but that's not the case.
In addition, American Financial Group has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Looking at the current analyst consensus data, we can see that the company's future payout ratio is expected to rise to 27% over the next three years. Despite the higher expected payout ratio, the company's ROE is not expected to change by much.
In total, it does look like American Financial Group has some positive aspects to its business. 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, on studying current analyst estimates, we were concerned to see that while the company has grown its earnings in the past, analysts expect its earnings to shrink in the future. 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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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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