Cognition Holdings Limited's (JSE:CGN) Stock is Soaring But Financials Seem Inconsistent: Will The Uptrend Continue?

Cognition Holdings' (JSE:CGN) stock is up by a considerable 12% over the past month. But the company's key financial indicators appear to be differing across the board and that makes us question whether or not the company's current share price momentum can be maintained. Specifically, we decided to study Cognition Holdings' ROE in this article.

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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

Check out our latest analysis for Cognition Holdings

How Do You Calculate Return On Equity?

ROE can be calculated by using the formula:

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

So, based on the above formula, the ROE for Cognition Holdings is:

4.1% = R9.7m ÷ R239m (Based on the trailing twelve months to June 2023).

The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each ZAR1 of shareholders' capital it has, the company made ZAR0.04 in profit.

Why Is ROE Important For Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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 all else is equal, companies that have both a higher return on equity and higher profit retention are usually the ones that have a higher growth rate when compared to companies that don't have the same features.

Cognition Holdings' Earnings Growth And 4.1% ROE

It is hard to argue that Cognition Holdings' ROE is much good in and of itself. Not just that, even compared to the industry average of 6.5%, the company's ROE is entirely unremarkable. Therefore, it might not be wrong to say that the five year net income decline of 47% seen by Cognition Holdings 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.

That being said, we compared Cognition Holdings' performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 3.1% in the same 5-year 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). This then helps them determine if the stock is placed for a bright or bleak future. 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 Cognition Holdings is trading on a high P/E or a low P/E, relative to its industry.

Is Cognition Holdings Using Its Retained Earnings Effectively?

Cognition Holdings doesn't pay any dividend, meaning that potentially all of its profits are being reinvested in the business, which doesn't explain why the company's earnings have shrunk if it is retaining all of its profits. So there could be some other explanations in that regard. For instance, the company's business may be deteriorating.

Summary

In total, we're a bit ambivalent about Cognition Holdings' performance. 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. Wrapping up, we would proceed with caution with this company and one way of doing that would be to look at the risk profile of the business. You can see the 3 risks we have identified for Cognition Holdings by visiting our risks dashboard for free on our platform here.

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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.