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Aferian (LON:AFRN) has had a rough three months with its share price down 5.4%. While this may simply be part of the stock market's rotation out of tech stocks, we decided to study the company's financials to determine if the downtrend will continue as the long-term performance of a company usually dictates market outcomes. In this article, we decided to focus on Aferian's ROE.
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.
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 Aferian is:
5.5% = US$5.8m ÷ US$104m (Based on the trailing twelve months to November 2021).
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 £0.06 in profit.
What Has ROE Got To Do With 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.
A Side By Side comparison of Aferian's Earnings Growth And 5.5% ROE
On the face of it, Aferian's ROE is not much to talk about. Next, when compared to the average industry ROE of 14%, the company's ROE leaves us feeling even less enthusiastic. For this reason, Aferian's five year net income decline of 23% is not surprising given its lower ROE. We reckon that there could also be other factors at play here. Such as - low earnings retention or poor allocation of capital.
However, when we compared Aferian's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 34% in the same period. This is quite worrisome.
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. Doing so will help them establish if the stock's future looks promising or ominous. Is Aferian fairly valued compared to other companies? These 3 valuation measures might help you decide.
Is Aferian Efficiently Re-investing Its Profits?
Aferian's declining earnings is not surprising given how the company is spending most of its profits in paying dividends, judging by its three-year median payout ratio of 66% (or a retention ratio of 34%). The business is only left with a small pool of capital to reinvest - Which could be harmful in the long-run if the company's earnings don't begin to grow organically. You can see the 3 risks we have identified for Aferian by visiting our risks dashboard for free on our platform here.
In addition, Aferian has been paying dividends over a period of at least ten years suggesting that maintaining high dividend payments is a key concern for management, even if it comes at the cost of business growth. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 44% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 12%, over the same period.
On the balance of these factors, we would encourage readers to review the risks before undertaking any investment action concerning Aferian. At present, the company is not reinvesting much into the business, and given the low ROE, it's not surprising to see very little in the way of earnings growth in recent periods. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. 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.
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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.