It is hard to get excited after looking at Cisco Systems' (NASDAQ:CSCO) recent performance, when its stock has declined 11% over the past three months. But if you pay close attention, you might find that its key financial indicators look quite decent, which could mean that the stock could potentially rise in the long-term given how markets usually reward more resilient long-term fundamentals. Specifically, we decided to study Cisco Systems' ROE in this article.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
How To Calculate Return On Equity?
Return on equity can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Cisco Systems is:
30% = US$11b ÷ US$38b (Based on the trailing twelve months to July 2020).
The 'return' is the amount earned after tax over the last twelve months. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.30.
What Has ROE Got To Do With Earnings Growth?
We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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 Cisco Systems' Earnings Growth And 30% ROE
First thing first, we like that Cisco Systems has an impressive ROE. Secondly, even when compared to the industry average of 6.7% the company's ROE is quite impressive. Given the circumstances, we can't help but wonder why Cisco Systems saw little to no growth in the past five years. So, there could be some other aspects that could potentially be preventing the company from growing. For example, it could be that the company has a high payout ratio or the business has allocated capital poorly, for instance.
As a next step, we compared Cisco Systems' net income growth with the industry and were disappointed to see that the company's growth is lower than the industry average growth of 3.6% in the same period.
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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. What is CSCO worth today? The intrinsic value infographic in our free research report helps visualize whether CSCO is currently mispriced by the market.
Is Cisco Systems Using Its Retained Earnings Effectively?
The high three-year median payout ratio of 54% (meaning, the company retains only 46% of profits) for Cisco Systems suggests that the company's earnings growth was miniscule as a result of paying out a majority of its earnings.
In addition, Cisco Systems has been paying dividends over a period of nine years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 47%. Accordingly, forecasts suggest that Cisco Systems' future ROE will be 30% which is again, similar to the current ROE.
In total, it does look like Cisco Systems has some positive aspects to its business. Yet, the low earnings growth is a bit concerning, especially given that the company has a high rate of return. Investors could have benefitted from the high ROE, had the company been reinvesting more of its earnings. As discussed earlier, the company is retaining a small portion of its profits. With that said, the latest industry analyst forecasts reveal that the company's earnings are expected to accelerate. 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.
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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