Most readers would already be aware that Class' (ASX:CL1) stock increased significantly by 40% over the past three months. However, we decided to pay close attention to its weak financials as we are doubtful that the current momentum will keep up, given the scenario. Particularly, we will be paying attention to Class' ROE today.
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
How To 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 Class is:
8.8% = AU$3.7m ÷ AU$42m (Based on the trailing twelve months to June 2021).
The 'return' is the income the business earned over the last year. So, this means that for every A$1 of its shareholder's investments, the company generates a profit of A$0.09.
What Is The Relationship Between ROE And 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 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.
Class' Earnings Growth And 8.8% ROE
When you first look at it, Class' ROE doesn't look that attractive. However, its ROE is similar to the industry average of 10%, so we won't completely dismiss the company. Having said that, Class' five year net income decline rate was 2.6%. Bear in mind, the company does have a slightly low ROE. Hence, this goes some way in explaining the shrinking earnings.
However, when we compared Class' growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 17% in the same period. This is quite worrisome.
Earnings growth is a huge factor in stock valuation. 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 CL1 fairly valued? This infographic on the company's intrinsic value has everything you need to know.
Is Class Efficiently Re-investing Its Profits?
With a high three-year median payout ratio of 76% (implying that 24% of the profits are retained), most of Class' profits are being paid to shareholders, which explains the company's shrinking earnings. With only a little being reinvested into the business, earnings growth would obviously be low or non-existent. To know the 4 risks we have identified for Class visit our risks dashboard for free.
Additionally, Class has paid dividends over a period of six years, which means that the company's management is rather focused on keeping up its dividend payments, regardless of the shrinking earnings. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 56% over the next three years. As a result, the expected drop in Class' payout ratio explains the anticipated rise in the company's future ROE to 18%, over the same period.
In total, we would have a hard think before deciding on any investment action concerning Class. The company has seen a lack of earnings growth as a result of retaining very little profits and whatever little it does retain, is being reinvested at a very low rate of return. That being so, the latest industry analyst forecasts show that the analysts are expecting to see a huge improvement in the company's earnings growth rate. 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.