American States Water (NYSE:AWR) has had a rough week with its share price down 2.6%. But if you pay close attention, you might gather that its strong financials could mean that the stock could potentially see an increase in value in the long-term, given how markets usually reward companies with good financial health. Specifically, we decided to study American States Water's ROE in this article.
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 American States Water is:
13% = US$83m ÷ US$634m (Based on the trailing twelve months to September 2020).
The 'return' is the income the business earned over the last year. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.13 in profit.
What Is The Relationship Between ROE And 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. 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 States Water's Earnings Growth And 13% ROE
At first glance, American States Water seems to have a decent ROE. Further, the company's ROE compares quite favorably to the industry average of 8.2%. This certainly adds some context to American States Water's decent 7.6% net income growth seen over the past five years.
Next, on comparing American States Water's net income growth with the industry, we found that the company's reported growth is similar to the industry average growth rate of 7.0% in the same period.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. This then helps them determine if the stock is placed for a bright or bleak future. Is American States Water fairly valued compared to other companies? These 3 valuation measures might help you decide.
Is American States Water Making Efficient Use Of Its Profits?
The high three-year median payout ratio of 53% (or a retention ratio of 47%) for American States Water suggests that the company's growth wasn't really hampered despite it returning most of its income to its shareholders.
Moreover, American States Water is determined to keep sharing its profits with shareholders which we infer from its long history of paying a dividend for at least ten years. Based on the latest analysts' estimates, we found that the company's future payout ratio over the next three years is expected to hold steady at 55%. Accordingly, forecasts suggest that American States Water's future ROE will be 13% which is again, similar to the current ROE.
On the whole, we feel that American States Water's performance has been quite good. We are particularly impressed by the considerable earnings growth posted by the company, which was likely backed by its high ROE. While the company is paying out most of its earnings as dividends, it has been able to grow its earnings in spite of it, so that's probably a good sign. Having said that, the company's earnings growth is expected to slow down, as forecasted in the current analyst estimates. 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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