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Most readers would already be aware that Federal Signal's (NYSE:FSS) stock increased significantly by 12% over the past three months. Given the company's impressive performance, we decided to study its financial indicators more closely as a company's financial health over the long-term usually dictates market outcomes. Particularly, we will be paying attention to Federal Signal's ROE today.
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 Is ROE Calculated?
ROE 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 Federal Signal is:
14% = US$96m ÷ US$702m (Based on the trailing twelve months to December 2020).
The 'return' is the profit over the last twelve months. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.14.
Why Is ROE Important For 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 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.
Federal Signal's Earnings Growth And 14% ROE
To begin with, Federal Signal seems to have a respectable ROE. Especially when compared to the industry average of 11% the company's ROE looks pretty impressive. This probably laid the ground for Federal Signal's moderate 19% net income growth seen over the past five years.
We then compared Federal Signal's net income growth with the industry and we're pleased to see that the company's growth figure is higher when compared with the industry which has a growth rate of 7.7% in the same period.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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. What is FSS worth today? The intrinsic value infographic in our free research report helps visualize whether FSS is currently mispriced by the market.
Is Federal Signal Using Its Retained Earnings Effectively?
Federal Signal has a low three-year median payout ratio of 20%, meaning that the company retains the remaining 80% of its profits. This suggests that the management is reinvesting most of the profits to grow the business.
Additionally, Federal Signal has paid dividends over a period of at least ten years which means that the company is pretty serious about sharing its profits with shareholders. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 17% of its profits over the next three years. Accordingly, forecasts suggest that Federal Signal's future ROE will be 15% which is again, similar to the current ROE.
On the whole, we feel that Federal Signal's performance has been quite good. Particularly, we like that the company is reinvesting heavily into its business, and at a high rate of return. Unsurprisingly, this has led to an impressive earnings growth. Having said that, the company's earnings growth is expected to slow down, as forecasted in the current analyst estimates. 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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