Most readers would already be aware that Adacel Technologies' (ASX:ADA) stock increased significantly by 14% 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. In this article, we decided to focus on Adacel Technologies' ROE.
ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
How Do You 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 Adacel Technologies is:
24% = AU$3.6m ÷ AU$15m (Based on the trailing twelve months to June 2020).
The 'return' is the amount earned after tax over the last twelve months. Another way to think of that is that for every A$1 worth of equity, the company was able to earn A$0.24 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.
Adacel Technologies' Earnings Growth And 24% ROE
First thing first, we like that Adacel Technologies has an impressive ROE. Second, a comparison with the average ROE reported by the industry of 13% also doesn't go unnoticed by us. As you might expect, the 29% net income decline reported by Adacel Technologies doesn't bode well with us. So, there might be some other aspects that could explain this. For example, it could be that the company has a high payout ratio or the business has allocated capital poorly, for instance.
However, when we compared Adacel Technologies' growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 11% in the same period. This is quite worrisome.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. Doing so will help them establish if the stock's future looks promising or ominous. Is ADA fairly valued? This infographic on the company's intrinsic value has everything you need to know.
Is Adacel Technologies Using Its Retained Earnings Effectively?
Looking at its three-year median payout ratio of 41% (or a retention ratio of 59%) which is pretty normal, Adacel Technologies' declining earnings is rather baffling as one would expect to see a fair bit of growth when a company is retaining a good portion of its profits. So there could be some other explanations in that regard. For instance, the company's business may be deteriorating.
In addition, Adacel Technologies has been paying dividends over a period of six years suggesting that keeping up dividend payments is preferred by the management even though earnings have been in decline. Looking at the current analyst consensus data, we can see that the company's future payout ratio is expected to rise to 72% over the next three years. Despite the higher expected payout ratio, the company's ROE is not expected to change by much.
In total, it does look like Adacel Technologies has some positive aspects to its business. However, given the high ROE and high profit retention, we would expect the company to be delivering strong earnings growth, but that isn't the case here. This suggests that there might be some external threat to the business, that's hampering its growth. 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. To know the 4 risks we have identified for Adacel Technologies visit our risks dashboard for free.
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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