Automatic Data Processing, Inc.'s (NASDAQ:ADP) Stock Has Seen Strong Momentum: Does That Call For Deeper Study Of Its Financial Prospects?

Automatic Data Processing (NASDAQ:ADP) has had a great run on the share market with its stock up by a significant 14% over the last month. We wonder if and what role the company's financials play in that price change as a company's long-term fundamentals usually dictate market outcomes. Particularly, we will be paying attention to Automatic Data Processing's ROE today.

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 short, ROE shows the profit each dollar generates with respect to its shareholder investments.

Check out our latest analysis for Automatic Data Processing

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 Automatic Data Processing is:

54% = US$2.7b ÷ US$5.0b (Based on the trailing twelve months to December 2021).

The 'return' is the profit over the last twelve months. That means that for every $1 worth of shareholders' equity, the company generated $0.54 in profit.

What Has ROE Got To Do With 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.

A Side By Side comparison of Automatic Data Processing's Earnings Growth And 54% ROE

Firstly, we acknowledge that Automatic Data Processing has a significantly high ROE. Additionally, the company's ROE is higher compared to the industry average of 17% which is quite remarkable. This probably laid the groundwork for Automatic Data Processing's moderate 9.8% net income growth seen over the past five years.

Next, on comparing with the industry net income growth, we found that Automatic Data Processing's reported growth was lower than the industry growth of 14% in the same period, which is not something we like to see.

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). Doing so will help them establish if the stock's future looks promising or ominous. Is ADP fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is Automatic Data Processing Efficiently Re-investing Its Profits?

The high three-year median payout ratio of 61% (or a retention ratio of 39%) for Automatic Data Processing suggests that the company's growth wasn't really hampered despite it returning most of its income to its shareholders.

Besides, Automatic Data Processing has been paying dividends for at least ten years or more. This shows that the company is committed to sharing profits with its shareholders. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 55%. Therefore, the company's future ROE is also not expected to change by much with analysts predicting an ROE of 56%.

Conclusion

On the whole, we do feel that Automatic Data Processing has some positive attributes. The company has grown its earnings moderately as previously discussed. Still, the high ROE could have been even more beneficial to investors had the company been reinvesting more of its profits. As highlighted earlier, the current reinvestment rate appears to be quite low. The latest industry analyst forecasts show that the company is expected to maintain its current growth rate. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.