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Arcosa's's (NYSE:ACA) stock is up by a considerable 26% over the past month. But the company's key financial indicators appear to be differing across the board and that makes us question whether or not the company's current share price momentum can be maintained. In this article, we decided to focus on Arcosa's 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. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.
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 Arcosa is:
6.3% = US$113m ÷ US$1.8b (Based on the trailing twelve months to December 2019).
The 'return' is the yearly profit. 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 learnt 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 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.
A Side By Side comparison of Arcosa's Earnings Growth And 6.3% ROE
At first glance, Arcosa's ROE doesn't look very promising. A quick further study shows that the company's ROE doesn't compare favorably to the industry average of 11% either. Given the circumstances, the significant decline in net income by 8.2% seen by Arcosa over the last five years is not surprising. 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 Arcosa's 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 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. Is ACA fairly valued? This infographic on the company's intrinsic value has everything you need to know.
Is Arcosa Making Efficient Use Of Its Profits?
Arcosa's low three-year median payout ratio of 8.1% (or a retention ratio of 92%) over the last three years should mean that the company is retaining most of its earnings to fuel its growth but the company's earnings have actually shrunk. This typically shouldn't be the case when a company is retaining most of its earnings. So there could be some other explanations in that regard. For example, the company's business may be deteriorating.
Additionally, Arcosa started paying a dividend only recently. So it looks like the management may have perceived that shareholders favor dividends even though earnings have been in decline. Our latest analyst data shows that the future payout ratio of the company is expected to rise to 13% over the next three years. Regardless, the future ROE for Arcosa is speculated to rise to 7.7% despite the anticipated increase in the payout ratio. There could probably be other factors that could be driving the future growth in the ROE.
On the whole, we feel that the performance shown by Arcosa can be open to many interpretations. While the company does have a high rate of reinvestment, the low ROE means that all that reinvestment is not reaping any benefit to its investors, and moreover, its having a negative impact on the earnings growth. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.
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