Should Weakness in Cognizant Technology Solutions Corporation's (NASDAQ:CTSH) Stock Be Seen As A Sign That Market Will Correct The Share Price Given Decent Financials?

Cognizant Technology Solutions (NASDAQ:CTSH) has had a rough three months with its share price down 16%. But if you pay close attention, you might find that its key financial indicators look quite decent, which could mean that the stock could potentially rise in the long-term given how markets usually reward more resilient long-term fundamentals. Specifically, we decided to study Cognizant Technology Solutions' ROE in this article.

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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.

Check out our latest analysis for Cognizant Technology Solutions

How To Calculate Return On Equity?

ROE 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 Cognizant Technology Solutions is:

18% = US$2.2b ÷ US$12b (Based on the trailing twelve months to March 2022).

The 'return' is the yearly profit. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.18 in profit.

Why Is ROE Important For Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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. 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.

Cognizant Technology Solutions' Earnings Growth And 18% ROE

At first glance, Cognizant Technology Solutions seems to have a decent ROE. And on comparing with the industry, we found that the the average industry ROE is similar at 17%. However, we are curious as to how Cognizant Technology Solutions' decent returns still resulted in flat growth for Cognizant Technology Solutions in the past five years. 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.

Next, on comparing with the industry net income growth, we found that Cognizant Technology Solutions' reported growth was lower than the industry growth of 15% in the same period, which is not something we like to see.

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. Doing so will help them establish if the stock's future looks promising or ominous. 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 Cognizant Technology Solutions is trading on a high P/E or a low P/E, relative to its industry.

Is Cognizant Technology Solutions Efficiently Re-investing Its Profits?

Despite having a moderate three-year median payout ratio of 26% (meaning the company retains74% of profits) in the last three-year period, Cognizant Technology Solutions' earnings growth was more or les flat. Therefore, there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.

Moreover, Cognizant Technology Solutions has been paying dividends for five years, which is a considerable amount of time, suggesting that management must have perceived that the shareholders prefer dividends over earnings growth. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 21% of its profits over the next three years. Therefore, the company's future ROE is also not expected to change by much with analysts predicting an ROE of 19%.

Summary

Overall, we feel that Cognizant Technology Solutions certainly does have some positive factors to consider. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE and and a high reinvestment rate. We believe that there might be some outside factors that could be having a negative impact on the business. Having said that, looking at the current analyst estimates, we found that the company's earnings are expected to gain momentum. 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. 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.