GR Engineering Services' (ASX:GNG) stock is up by a considerable 16% over the past week. 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. Particularly, we will be paying attention to GR Engineering Services' 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 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 GR Engineering Services is:
52% = AU$29m ÷ AU$56m (Based on the trailing twelve months to December 2021).
The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each A$1 of shareholders' capital it has, the company made A$0.52 in profit.
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.
GR Engineering Services' Earnings Growth And 52% ROE
To begin with, GR Engineering Services has a pretty high ROE which is interesting. Second, a comparison with the average ROE reported by the industry of 16% also doesn't go unnoticed by us. However, for some reason, the higher returns aren't reflected in GR Engineering Services' meagre five year net income growth average of 4.9%. This is generally not the case as when a company has a high rate of return it should usually also have a high earnings growth rate. Such a scenario is likely to take place when a company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.
We then compared GR Engineering Services' net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 26% in the same period, which is a bit concerning.
Earnings growth is an important metric to consider when valuing a stock. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. One good indicator of expected earnings growth is the P/E ratio which determines the price the market is willing to pay for a stock based on its earnings prospects. So, you may want to check if GR Engineering Services is trading on a high P/E or a low P/E, relative to its industry.
Is GR Engineering Services Making Efficient Use Of Its Profits?
With a high three-year median payout ratio of 85% (or a retention ratio of 15%), most of GR Engineering Services' profits are being paid to shareholders. This definitely contributes to the low earnings growth seen by the company.
Additionally, GR Engineering Services has paid dividends over a period of at least ten years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth.
Overall, we feel that GR Engineering Services certainly does have some positive factors to consider. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE. Bear in mind, the company reinvests a small portion of its profits, which means that investors aren't reaping the benefits of the high rate of return. While we won't completely dismiss the company, what we would do, is try to ascertain how risky the business is to make a more informed decision around the company. You can see the 1 risk we have identified for GR Engineering Services by visiting our risks dashboard for free on our platform here.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.