Can Mixed Financials Have A Negative Impact on Southwest Airlines Co.'s 's (NYSE:LUV) Current Price Momentum?

Southwest Airlines' (NYSE:LUV) stock up by 4.5% over the past three months. Given that the stock prices usually follow long-term business performance, we wonder if the company's mixed financials could have any adverse effect on its current price price movement In this article, we decided to focus on Southwest Airlines' ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. 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 Southwest Airlines

How Do You 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 Southwest Airlines is:

0.7% = US$78m ÷ US$10b (Based on the trailing twelve months to June 2024).

The 'return' is the amount earned after tax over the last twelve months. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.01 in profit.

What Has ROE Got To Do With Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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. 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.

A Side By Side comparison of Southwest Airlines' Earnings Growth And 0.7% ROE

It is hard to argue that Southwest Airlines' ROE is much good in and of itself. Even when compared to the industry average of 9.2%, the ROE figure is pretty disappointing. Therefore, it might not be wrong to say that the five year net income decline of 8.9% seen by Southwest Airlines was possibly a result of it having a lower ROE. We believe that there also might be other aspects that are negatively influencing the company's earnings prospects. For instance, the company has a very high payout ratio, or is faced with competitive pressures.

So, as a next step, we compared Southwest Airlines' performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 14% over the last few years.

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. 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 Southwest Airlines is trading on a high P/E or a low P/E, relative to its industry.

Is Southwest Airlines Using Its Retained Earnings Effectively?

Despite having a normal three-year median payout ratio of 37% (where it is retaining 63% of its profits), Southwest Airlines has seen a decline in earnings as we saw above. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.

Moreover, Southwest Airlines 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. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 28% over the next three years. As a result, the expected drop in Southwest Airlines' payout ratio explains the anticipated rise in the company's future ROE to 10%, over the same period.

Conclusion

On the whole, we feel that the performance shown by Southwest Airlines can be open to many interpretations. While the company does have a high rate of reinvestment, the low ROE means that all that reinvestment is not reaping any benefit to its investors, and moreover, its having a negative impact on the earnings growth. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. 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.