Most readers would already be aware that Mercury General's (NYSE:MCY) stock increased significantly by 11% over the past month. Given the company's impressive performance, we decided to study its financial indicators more closely as a company's financial health over the long-term usually dictates market outcomes. In this article, we decided to focus on Mercury General'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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
How To Calculate Return On Equity?
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 Mercury General is:
13% = US$240m ÷ US$1.9b (Based on the trailing twelve months to September 2020).
The 'return' is the income the business earned over the last year. That means that for every $1 worth of shareholders' equity, the company generated $0.13 in profit.
What Is The Relationship Between ROE And Earnings Growth?
We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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.
Mercury General's Earnings Growth And 13% ROE
To start with, Mercury General's ROE looks acceptable. Especially when compared to the industry average of 8.1% the company's ROE looks pretty impressive. This certainly adds some context to Mercury General's exceptional 24% net income growth seen over the past five years. However, there could also be other causes behind this growth. Such as - high earnings retention or an efficient management in place.
Next, on comparing with the industry net income growth, we found that Mercury General's growth is quite high when compared to the industry average growth of 7.0% in the same period, which is great to see.
Earnings growth is an important metric to consider when valuing a stock. 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. If you're wondering about Mercury General's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.
Is Mercury General Making Efficient Use Of Its Profits?
Mercury General's significant three-year median payout ratio of 80% (where it is retaining only 20% of its income) suggests that the company has been able to achieve a high growth in earnings despite returning most of its income to shareholders.
Additionally, Mercury General 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 71% of its profits over the next three years.
In total, we are pretty happy with Mercury General's performance. In particular, its high ROE is quite noteworthy and also the probable explanation behind its considerable earnings growth. Yet, the company is retaining a small portion of its profits. Which means that the company has been able to grow its earnings in spite of it, so that's not too bad. That being so, according to the latest industry analyst forecasts, the company's earnings are expected to shrink in the future. 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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