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ARC Resources Ltd.'s (TSE:ARX) Stock Has Seen Strong Momentum: Does That Call For Deeper Study Of Its Financial Prospects?

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ARC Resources (TSE:ARX) has had a great run on the share market with its stock up by a significant 21% over the last three months. As most would know, fundamentals are what usually guide market price movements over the long-term, so we decided to look at the company's key financial indicators today to determine if they have any role to play in the recent price movement. Specifically, we decided to study ARC Resources' 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. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

View our latest analysis for ARC Resources

How Is ROE Calculated?

The formula for return on equity is:

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

So, based on the above formula, the ROE for ARC Resources is:

13% = CA$787m ÷ CA$5.9b (Based on the trailing twelve months to December 2021).

The 'return' is the income the business earned over the last year. So, this means that for every CA$1 of its shareholder's investments, the company generates a profit of CA$0.13.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don’t share these attributes.

A Side By Side comparison of ARC Resources' Earnings Growth And 13% ROE

To begin with, ARC Resources seems to have a respectable ROE. Even so, when compared with the average industry ROE of 17%, we aren't very excited. Further research shows that ARC Resources' net income has shrunk at a rate of 25% over the last five years. Bear in mind, the company does have a high ROE. It is just that the industry ROE is higher. So there might be other reasons for the earnings to shrink. 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 ARC Resources' growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 5.0% in the same period. This is quite worrisome.

past-earnings-growth
past-earnings-growth

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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Has the market priced in the future outlook for ARX? You can find out in our latest intrinsic value infographic research report.

Is ARC Resources Using Its Retained Earnings Effectively?

In spite of a normal three-year median payout ratio of 45% (that is, a retention ratio of 55%), the fact that ARC Resources' earnings have shrunk is quite puzzling. So there could be some other explanations in that regard. For instance, the company's business may be deteriorating.

Additionally, ARC Resources has paid dividends over a period of at least ten years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 27% over the next three years.

Conclusion

On the whole, we do feel that ARC Resources has some positive attributes. Yet, the low earnings growth is a bit concerning, especially given that the company has a respectable rate of return and is reinvesting a huge portion of its profits. By the looks of it, there could be some other factors, not necessarily in control of the business, that's preventing growth. 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.

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

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.