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It is hard to get excited after looking at Autoliv's (NYSE:ALV) recent performance, when its stock has declined 2.3% over the past week. Given that stock prices are usually driven by a company’s fundamentals over the long term, which in this case look pretty weak, we decided to study the company's key financial indicators. In this article, we decided to focus on Autoliv'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. 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 return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Autoliv is:
7.8% = US$188m ÷ US$2.4b (Based on the trailing twelve months to December 2020).
The 'return' is the yearly profit. That means that for every $1 worth of shareholders' equity, the company generated $0.08 in profit.
What Is The Relationship Between ROE And 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 Autoliv's Earnings Growth And 7.8% ROE
On the face of it, Autoliv's ROE is not much to talk about. We then compared the company's ROE to the broader industry and were disappointed to see that the ROE is lower than the industry average of 13%. Therefore, it might not be wrong to say that the five year net income decline of 18% seen by Autoliv was probably the result of it having a lower ROE. We believe that there also might be other aspects that are negatively influencing the company's earnings prospects. Such as - low earnings retention or poor allocation of capital.
That being said, we compared Autoliv's performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 5.4% in the same period.
Earnings growth is a huge factor in stock valuation. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. This then helps them determine if the stock is placed for a bright or bleak future. Is ALV fairly valued? This infographic on the company's intrinsic value has everything you need to know.
Is Autoliv Making Efficient Use Of Its Profits?
While the company did payout a portion of its dividend in the past, it currently doesn't pay a dividend. This implies that potentially all of its profits are being reinvested in the business.
Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 26% over the next three years. As a result, the expected drop in Autoliv's payout ratio explains the anticipated rise in the company's future ROE to 22%, over the same period.
On the whole, Autoliv's performance is quite a big let-down. The company has seen a lack of earnings growth as a result of retaining very little profits and whatever little it does retain, is being reinvested at a very low rate of return. 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. 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.
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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