With its stock down 22% over the past three months, it is easy to disregard American Software (NASDAQ:AMSW.A). We decided to study the company's financials to determine if the downtrend will continue as the long-term performance of a company usually dictates market outcomes. Particularly, we will be paying attention to American Software's ROE today.
ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.
How Is ROE Calculated?
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 American Software is:
9.4% = US$12m ÷ US$131m (Based on the trailing twelve months to January 2022).
The 'return' is the income the business earned over the last year. That means that for every $1 worth of shareholders' equity, the company generated $0.09 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. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. 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.
A Side By Side comparison of American Software's Earnings Growth And 9.4% ROE
At first glance, American Software's ROE doesn't look very promising. However, its ROE is similar to the industry average of 11%, so we won't completely dismiss the company. But American Software saw a five year net income decline of 12% over the past five years. Bear in mind, the company does have a slightly low ROE. Therefore, the decline in earnings could also be the result of this.
However, when we compared American Software's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 20% in the same period. This is quite worrisome.
Earnings growth is an important metric to consider when valuing a stock. 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. What is AMSW.A worth today? The intrinsic value infographic in our free research report helps visualize whether AMSW.A is currently mispriced by the market.
Is American Software Using Its Retained Earnings Effectively?
American Software's very high three-year median payout ratio of 194% over the last three years suggests that the company is paying its shareholders more than what it is earning and this explains the company's shrinking earnings. Paying a dividend beyond their means is usually not viable over the long term. You can see the 4 risks we have identified for American Software by visiting our risks dashboard for free on our platform here.
Moreover, American Software 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.
On the whole, American Software's performance is quite a big let-down. The low ROE, combined with the fact that the company is paying out almost if not all, of its profits as dividends, has resulted in the lack or absence of growth in its earnings. That being so, the latest industry analyst forecasts show that the analysts are expecting to see a huge improvement in the company's earnings 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.
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.