Most readers would already be aware that Kaap Agri's (JSE:KAL) stock increased significantly by 32% over the past three months. 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. Specifically, we decided to study Kaap Agri'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 ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Kaap Agri is:
13% = R279m ÷ R2.1b (Based on the trailing twelve months to September 2020).
The 'return' is the amount earned after tax over the last twelve months. So, this means that for every ZAR1 of its shareholder's investments, the company generates a profit of ZAR0.13.
Why Is ROE Important For Earnings Growth?
Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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. 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.
Kaap Agri's Earnings Growth And 13% ROE
When you first look at it, Kaap Agri's ROE doesn't look that attractive. We then compared the company's ROE to the broader industry and were disappointed to see that the ROE is lower than the industry average of 25%. Kaap Agri was still able to see a decent net income growth of 7.4% over the past five years. So, the growth in the company's earnings could probably have been caused by other variables. Such as - high earnings retention or an efficient management in place.
Next, on comparing with the industry net income growth, we found that Kaap Agri's growth is quite high when compared to the industry average growth of 4.5% in the same period, which is great to see.
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. 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 Kaap Agri is trading on a high P/E or a low P/E, relative to its industry.
Is Kaap Agri Efficiently Re-investing Its Profits?
Kaap Agri has a healthy combination of a moderate three-year median payout ratio of 26% (or a retention ratio of 74%) and a respectable amount of growth in earnings as we saw above, meaning that the company has been making efficient use of its profits.
Besides, Kaap Agri has been paying dividends over a period of three years. This shows that the company is committed to sharing profits with its shareholders.
In total, it does look like Kaap Agri has some positive aspects to its business. With a high rate of reinvestment, albeit at a low ROE, the company has managed to see a considerable growth in its earnings. While we won't completely dismiss the company, what we would do, is try to ascertain how risky the business is to make a more informed decision around the company. Our risks dashboard would have the 2 risks we have identified for Kaap Agri.
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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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