Packaging Corporation of America (NYSE:PKG) has had a rough month with its share price down 6.9%. However, the company's fundamentals look pretty decent, and long-term financials are usually aligned with future market price movements. In this article, we decided to focus on Packaging Corporation of America's ROE.
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
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 Packaging Corporation of America is:
15% = US$486m ÷ US$3.3b (Based on the trailing twelve months to March 2021).
The 'return' is the profit over the last twelve months. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.15 in profit.
Why Is ROE Important For Earnings Growth?
We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. 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.
Packaging Corporation of America's Earnings Growth And 15% ROE
To begin with, Packaging Corporation of America seems to have a respectable ROE. Further, the company's ROE is similar to the industry average of 16%. Despite the moderate return on equity, Packaging Corporation of America has posted a net income growth of 4.3% over the past five years. We reckon that a low growth, when returns are moderate could be the result of certain circumstances like low earnings retention or poor allocation of capital.
We then compared Packaging Corporation of America's net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 12% in the same period, which is a bit concerning.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Has the market priced in the future outlook for PKG? You can find out in our latest intrinsic value infographic research report.
Is Packaging Corporation of America Using Its Retained Earnings Effectively?
Despite having a moderate three-year median payout ratio of 39% (implying that the company retains the remaining 61% of its income), Packaging Corporation of America's earnings growth was quite low. So there could be some other explanation in that regard. For instance, the company's business may be deteriorating.
Moreover, Packaging Corporation of America has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over earnings growth. Our latest analyst data shows that the future payout ratio of the company is expected to rise to 50% over the next three years. Regardless, the future ROE for Packaging Corporation of America is speculated to rise to 20% despite the anticipated increase in the payout ratio. There could probably be other factors that could be driving the future growth in the ROE.
Overall, we feel that Packaging Corporation of America certainly does have some positive factors to consider. Yet, the low earnings growth is a bit concerning, especially given that the company has a high rate of return and is reinvesting ma huge portion of its profits. By the looks of it, there could be some other factors, not necessarily in control of the business, that's preventing growth. Having said that, looking at the current analyst estimates, we found that the company's earnings are expected to gain momentum. 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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