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RM plc's (LON:RM.) Fundamentals Look Pretty Strong: Could The Market Be Wrong About The Stock?

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It is hard to get excited after looking at RM's (LON:RM.) recent performance, when its stock has declined 2.7% over the past week. However, stock prices are usually driven by a company’s financials over the long term, which in this case look pretty respectable. Particularly, we will be paying attention to RM's 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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

Check out our latest analysis for RM

How Do You Calculate Return On Equity?

Return on equity 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 RM is:

15% = UK£8.4m ÷ UK£55m (Based on the trailing twelve months to November 2020).

The 'return' is the profit over the last twelve months. One way to conceptualize this is that for each £1 of shareholders' capital it has, the company made £0.15 in profit.

What Is The Relationship Between ROE And Earnings Growth?

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

RM's Earnings Growth And 15% ROE

To start with, RM's ROE looks acceptable. And on comparing with the industry, we found that the the average industry ROE is similar at 13%. Despite the moderate return on equity, RM has posted a net income growth of 3.4% over the past five years. We reckon that a low growth, when returns are moderate could be the result of certain circumstances like low earnings retention or poor allocation of capital.

Next, on comparing with the industry net income growth, we found that RM's reported growth was lower than the industry growth of 13% in the same period, which is not something we like to see.

past-earnings-growth
past-earnings-growth

Earnings growth is a huge factor in stock valuation. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. What is RM. worth today? The intrinsic value infographic in our free research report helps visualize whether RM. is currently mispriced by the market.

Is RM Efficiently Re-investing Its Profits?

Despite having a normal three-year median payout ratio of 35% (or a retention ratio of 65% over the past three years, RM has seen very little growth in earnings as we saw above. So there could be some other explanation in that regard. For instance, the company's business may be deteriorating.

In addition, RM has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 27% over the next three years. The fact that the company's ROE is expected to rise to 25% over the same period is explained by the drop in the payout ratio.

Conclusion

Overall, we feel that RM certainly does have some positive factors to consider. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE and and a high reinvestment rate. We believe that there might be some outside factors that could be having a negative impact on the business. Having said that, looking at the current analyst estimates, we found that the company's earnings are expected to gain momentum. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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