Do Its Financials Have Any Role To Play In Driving Magic Software Enterprises Ltd.'s (NASDAQ:MGIC) Stock Up Recently?

Most readers would already be aware that Magic Software Enterprises' (NASDAQ:MGIC) stock increased significantly by 17% over the past three months. 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. In this article, we decided to focus on Magic Software Enterprises' 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 other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

View our latest analysis for Magic Software Enterprises

How To Calculate Return On Equity?

The formula for ROE is:

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

So, based on the above formula, the ROE for Magic Software Enterprises is:

10% = US$30m ÷ US$294m (Based on the trailing twelve months to December 2020).

The 'return' is the yearly profit. That means that for every $1 worth of shareholders' equity, the company generated $0.10 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. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. 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.

Magic Software Enterprises' Earnings Growth And 10% ROE

To start with, Magic Software Enterprises' ROE looks acceptable. And on comparing with the industry, we found that the the average industry ROE is similar at 12%. Despite the modest returns, Magic Software Enterprises' five year net income growth was quite low, averaging at only 4.7%. So, there could be some other factors at play that could be impacting the company's growth. For instance, the company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.

As a next step, we compared Magic Software Enterprises' net income growth with the industry and were disappointed to see that the company's growth is lower than the industry average growth of 28% in the same period.

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). By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is MGIC fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is Magic Software Enterprises Making Efficient Use Of Its Profits?

The high three-year median payout ratio of 79% (that is, the company retains only 21% of its income) over the past three years for Magic Software Enterprises suggests that the company's earnings growth was lower as a result of paying out a majority of its earnings.

Additionally, Magic Software Enterprises has paid dividends over a period of nine years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth.

Conclusion

On the whole, we do feel that Magic Software Enterprises has some positive attributes. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE. Bear in mind, the company reinvests a small portion of its profits, which means that investors aren't reaping the benefits of the high rate of return. That being so, the latest analyst forecasts show that the company will continue to see an expansion in its earnings. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.

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This article by Simply Wall St is general in nature. 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.
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