Most readers would already be aware that Cognizant Technology Solutions' (NASDAQ:CTSH) stock increased significantly by 27% over the past three months. We wonder if and what role the company's financials play in that price change as a company's long-term fundamentals usually dictate market outcomes. Specifically, we decided to study Cognizant Technology Solutions' ROE in this article.
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 return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Cognizant Technology Solutions is:
15% = US$1.6b ÷ US$11b (Based on the trailing twelve months to June 2020).
The 'return' is the income the business earned over the last year. That means that for every $1 worth of shareholders' equity, the company generated $0.15 in profit.
What Has ROE Got To Do With 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. 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.
Cognizant Technology Solutions' Earnings Growth And 15% ROE
To start with, Cognizant Technology Solutions' ROE looks acceptable. Further, the company's ROE is similar to the industry average of 15%. Despite the modest returns, Cognizant Technology Solutions' five year net income growth was quite low, averaging at only 4.0%. So, there could be some other factors at play that could be impacting the company's growth. For instance, the company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.
As a next step, we compared Cognizant Technology Solutions' net income growth with the industry and were disappointed to see that the company's growth is lower than the industry average growth of 9.0% in the same period.
Earnings growth is a huge factor in stock valuation. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. Doing so will help them establish if the stock's future looks promising or ominous. Is Cognizant Technology Solutions fairly valued compared to other companies? These 3 valuation measures might help you decide.
Is Cognizant Technology Solutions Using Its Retained Earnings Effectively?
Cognizant Technology Solutions' low three-year median payout ratio of 23% (or a retention ratio of 77%) should mean that the company is retaining most of its earnings to fuel its growth. However, the low earnings growth number doesn't reflect this as high growth usually follows high profit retention. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.
Additionally, Cognizant Technology Solutions has paid dividends over a period of three years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth. Looking at the current analyst consensus data, we can see that the company's future payout ratio is expected to rise to 34% over the next three years. Still, forecasts suggest that Cognizant Technology Solutions' future ROE will rise to 18% even though the the company's payout ratio is expected to rise. We presume that there could some other characteristics of the business that could be driving the anticipated growth in the company's ROE.
On the whole, we do feel that Cognizant Technology Solutions has some positive attributes. Yet, the low earnings growth is a bit concerning, especially given that the company has a high rate of return and is reinvesting ma 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 analyst forecasts show that the company will continue to see an expansion in its earnings. 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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