Electronic Arts' (NASDAQ:EA) stock is up by a considerable 7.9% over the past month. Given that the market rewards strong financials in the long-term, we wonder if that is the case in this instance. In this article, we decided to focus on Electronic Arts' ROE.
Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
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 Electronic Arts is:
15% = US$1.2b ÷ US$8.0b (Based on the trailing twelve months to December 2020).
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. 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. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don’t share these attributes.
Electronic Arts' Earnings Growth And 15% ROE
To begin with, Electronic Arts seems to have a respectable ROE. Even when compared to the industry average of 14% the company's ROE looks quite decent. This probably goes some way in explaining Electronic Arts' moderate 17% growth over the past five years amongst other factors.
We then compared Electronic Arts' net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 39% in the same period, which is a bit concerning.
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. This then helps them determine if the stock is placed for a bright or bleak future. 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 Electronic Arts is trading on a high P/E or a low P/E, relative to its industry.
Is Electronic Arts Using Its Retained Earnings Effectively?
Electronic Arts' three-year median payout ratio to shareholders is 4.2% (implying that it retains 96% of its income), which is on the lower side, so it seems like the management is reinvesting profits heavily to grow its business.
Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to rise to 6.4% over the next three years. However, the company's ROE is not expected to change by much despite the higher expected payout ratio.
In total, we are pretty happy with Electronic Arts' performance. Specifically, we like that the company is reinvesting a huge chunk of its profits at a high rate of return. This of course has caused the company to see a good amount of growth in its earnings. We also studied the latest analyst forecasts and found that the company's earnings growth is expected be similar to its current growth rate. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page 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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