With just one trading session left in 2021, Alphabet's ( NASDAQ:GOOG ) stock price is up 67% YTD, and the company is set to be the top performer amongst the trillion dollar tech companies this year. The share price gain has been backed up by exceptional earnings growth of 97.7% over the last year.
Going forward, analysts are expecting a significant slowdown in earnings growth, which may weigh on the share price in 2022. However, forecastsing Alphabet’s earnings is very challenging and estimates often turn out to be too conservative. In light of this we decided to have a look at the company’s ROE to see what it may suggest about future growth.
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.
How Do You Calculate Return On Equity?
Return on equity can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Alphabet is:
29% = US$71b ÷ US$245b (Based on the trailing twelve months to September 2021).
The 'return' refers to a company's earnings over the last year.Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.29 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.
Alphabet's Earnings Growth And 29% ROE
Firstly, we acknowledge that Alphabet has a significantly high ROE.Second, a comparison with the average ROE reported by the industry of 13% also doesn't go unnoticed by us.So, the substantial 27% net income growth seen by Alphabet over the past five years isn't overly surprising.
Next, on comparing with the industry net income growth, we found that Alphabet's growth is quite high when compared to the industry average growth of 21% in the same period, which is great to see.
Earnings growth is a huge factor in stock valuation.The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. This then helps them determine if the stock is placed for a bright or bleak future. Has the market priced in the future outlook for GOOG? You can find out in our latest intrinsic value infographic research report.
Is Alphabet Using Its Retained Earnings Effectively?
Given that Alphabet doesn't pay any dividend to its shareholders, we infer that the company has been reinvesting all of its profits to grow its business. This also implies that the company still has opportunities to reinvest capital which is a good sign.
As mentioned, Alphabet’s price performance has been driven by exceptional earnings growth over the last 12 months. It will be difficult to deliver those numbers again in 2022, but the good news is that the stock appears to be reasonably priced. Our estimate of Alphabet's fair value is $4,853 and the stock is still 40% below that level. So, if growth does slow, a correction may be quite shallow.
The impressive ROE points to strong earning potential over the longer term, so any weakness in 2022 may be a buying opportunity. If you would like to keep track of the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.
Simply Wall St analyst Richard Bowman and Simply Wall St have no position in any of the companies mentioned. This article 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.