Most readers would already be aware that Paychex's (NASDAQ:PAYX) stock increased significantly by 6.2% over the past month. Given that stock prices are usually aligned with a company's financial performance in the long-term, we decided to study its financial indicators more closely to see if they had a hand to play in the recent price move. In this article, we decided to focus on Paychex's ROE.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
How Is ROE Calculated?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Paychex is:
37% = US$1.1b ÷ US$2.9b (Based on the trailing twelve months to November 2020).
The 'return' is the income the business earned over the last year. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.37.
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.
Paychex's Earnings Growth And 37% ROE
First thing first, we like that Paychex has an impressive ROE. Additionally, the company's ROE is higher compared to the industry average of 14% which is quite remarkable. Probably as a result of this, Paychex was able to see a decent net income growth of 9.1% over the last five years.
As a next step, we compared Paychex's net income growth with the industry and were disappointed to see that the company's growth is lower than the industry average growth of 12% in the same period.
Earnings growth is an important metric to consider when valuing a stock. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is Paychex fairly valued compared to other companies? These 3 valuation measures might help you decide.
Is Paychex Making Efficient Use Of Its Profits?
The high three-year median payout ratio of 80% (or a retention ratio of 20%) for Paychex suggests that the company's growth wasn't really hampered despite it returning most of its income to its shareholders.
Additionally, Paychex has paid dividends over a period of at least ten years which means that the company is pretty serious about sharing its profits with shareholders. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 77%. As a result, Paychex's ROE is not expected to change by much either, which we inferred from the analyst estimate of 38% for future ROE.
In total, it does look like Paychex has some positive aspects to its business. Its earnings have grown respectably as we saw earlier, which was likely due to the company reinvesting its earnings at a pretty high rate of return. However, given the high ROE, we do think that the company is reinvesting a small portion of its profits. This could likely be preventing the company from growing to its full extent. On studying current analyst estimates, we found that analysts expect the company to continue its recent growth streak. 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. 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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