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Graham (NYSE:GHM) has had a rough month with its share price down 15%. 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 Graham's ROE.
Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. Put another way, it reveals the company's success at turning shareholder investments into profits.
How Do You 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 Graham is:
2.6% = US$2.6m ÷ US$97m (Based on the trailing twelve months to December 2020).
The 'return' is the profit over the last twelve months. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.03 in profit.
What Is The Relationship Between ROE And Earnings Growth?
We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. 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.
Graham's Earnings Growth And 2.6% ROE
As you can see, Graham's ROE looks pretty weak. Even compared to the average industry ROE of 11%, the company's ROE is quite dismal. Given the circumstances, the significant decline in net income by 29% seen by Graham over the last five years is not surprising. However, there could also be other factors causing the earnings to decline. Such as - low earnings retention or poor allocation of capital.
That being said, we compared Graham'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 7.8% in the same period.
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). This then helps them determine if the stock is placed for a bright or bleak future. If you're wondering about Graham's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.
Is Graham Making Efficient Use Of Its Profits?
With a LTM (or last twelve month) payout ratio as high as 171%,Graham's shrinking earnings don't come as a surprise as the company is paying a dividend which is beyond its means. Paying a dividend beyond their means is usually not viable over the long term. Our risks dashboard should have the 2 risks we have identified for Graham.
In addition, Graham has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth.
On the whole, Graham's performance is quite a big let-down. Specifically, it has shown quite an unsatisfactory performance as far as earnings growth is concerned, and a poor ROE and an equally poor rate of reinvestment seem to be the reason behind this inadequate performance. 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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