Declining Stock and Solid Fundamentals: Is The Market Wrong About Arthur J. Gallagher & Co. (NYSE:AJG)?

With its stock down 6.7% over the past week, it is easy to disregard Arthur J. Gallagher (NYSE:AJG). 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. Specifically, we decided to study Arthur J. Gallagher's ROE in this article.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Put another way, it reveals the company's success at turning shareholder investments into profits.

View our latest analysis for Arthur J. Gallagher

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 Arthur J. Gallagher is:

12% = US$987m ÷ US$8.5b (Based on the trailing twelve months to September 2021).

The 'return' refers to a company's earnings over the last year. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.12.

What Has ROE Got To Do With 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. 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.

A Side By Side comparison of Arthur J. Gallagher's Earnings Growth And 12% ROE

To start with, Arthur J. Gallagher's ROE looks acceptable. Further, the company's ROE is similar to the industry average of 11%. This probably goes some way in explaining Arthur J. Gallagher's moderate 15% growth over the past five years amongst other factors.

Next, on comparing with the industry net income growth, we found that Arthur J. Gallagher's growth is quite high when compared to the industry average growth of 12% in the same period, which is great to see.

Earnings growth is an important metric to consider when valuing a stock. 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. Has the market priced in the future outlook for AJG? You can find out in our latest intrinsic value infographic research report.

Is Arthur J. Gallagher Using Its Retained Earnings Effectively?

Arthur J. Gallagher has a healthy combination of a moderate three-year median payout ratio of 45% (or a retention ratio of 55%) and a respectable amount of growth in earnings as we saw above, meaning that the company has been making efficient use of its profits.

Moreover, Arthur J. Gallagher 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. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 30% over the next three years. The fact that the company's ROE is expected to rise to 15% over the same period is explained by the drop in the payout ratio.

Conclusion

In total, we are pretty happy with Arthur J. Gallagher's performance. 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. That being so, the latest analyst forecasts show that the company will continue to see an expansion in its earnings. 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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.