Should Weakness in Electronic Arts Inc.'s (NASDAQ:EA) Stock Be Seen As A Sign That Market Will Correct The Share Price Given Decent Financials?

With its stock down 9.9% over the past month, it is easy to disregard Electronic Arts (NASDAQ:EA). However, stock prices are usually driven by a company’s financials over the long term, which in this case look pretty respectable. 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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.

See our latest analysis for Electronic Arts

How Is ROE Calculated?

The formula for ROE is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Electronic Arts is:

14% = US$1.0b ÷ US$7.4b (Based on the trailing twelve months to September 2024).

The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.14 in profit.

What Has ROE Got To Do With Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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 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.

Electronic Arts' Earnings Growth And 14% ROE

To start with, Electronic Arts' ROE looks acceptable. Even when compared to the industry average of 14% the company's ROE looks quite decent. For this reason, Electronic Arts' five year net income decline of 22% raises the question as to why the decent ROE didn't translate into growth. Based on this, we feel that there might be other reasons which haven't been discussed so far in this article that could be hampering the company's growth. These include low earnings retention or poor allocation of capital.

However, when we compared Electronic Arts' growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 22% in the same period. This is quite worrisome.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. Doing so will help them establish if the stock's future looks promising or ominous. What is EA worth today? The intrinsic value infographic in our free research report helps visualize whether EA is currently mispriced by the market.

Is Electronic Arts Making Efficient Use Of Its Profits?

Electronic Arts' low three-year median payout ratio of 22% (implying that it retains the remaining 78% of its profits) comes as a surprise when you pair it with the shrinking earnings. This typically shouldn't be the case when a company is retaining most of its earnings. It looks like there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.

Moreover, Electronic Arts has been paying dividends for four years, which is a considerable amount of time, suggesting that management must have perceived that the shareholders prefer consistent dividends even though earnings have been shrinking. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 8.7% over the next three years. As a result, the expected drop in Electronic Arts' payout ratio explains the anticipated rise in the company's future ROE to 20%, over the same period.

Summary

On the whole, we do feel that Electronic Arts has some positive attributes. 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. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow 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. 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.