Graham Holdings Company's (NYSE:GHC) Stock Is Rallying But Financials Look Ambiguous: Will The Momentum Continue?
Graham Holdings (NYSE:GHC) has had a great run on the share market with its stock up by a significant 14% over the last three months. However, we decided to pay attention to the company's fundamentals which don't appear to give a clear sign about the company's financial health. Specifically, we decided to study Graham Holdings' 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. Put another way, it reveals the company's success at turning shareholder investments into profits.
See our latest analysis for Graham Holdings
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 Holdings is:
4.3% = US$163m ÷ US$3.8b (Based on the trailing twelve months to September 2023).
The 'return' is the amount earned after tax over the last twelve months. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.04 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. 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. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don’t share these attributes.
A Side By Side comparison of Graham Holdings' Earnings Growth And 4.3% ROE
At first glance, Graham Holdings' ROE doesn't look very promising. A quick further study shows that the company's ROE doesn't compare favorably to the industry average of 10% either. Therefore, it might not be wrong to say that the five year net income decline of 13% seen by Graham Holdings was probably the result of it having a lower ROE. We reckon that there could also be other factors at play here. For instance, the company has a very high payout ratio, or is faced with competitive pressures.
So, as a next step, we compared Graham Holdings' performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 20% over the last few years.
Earnings growth is an important metric to consider when valuing a stock. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. 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 Graham Holdings is trading on a high P/E or a low P/E, relative to its industry.
Is Graham Holdings Making Efficient Use Of Its Profits?
When we piece together Graham Holdings' low three-year median payout ratio of 14% (where it is retaining 86% of its profits), calculated for the last three-year period, we are puzzled by the lack of growth. This typically shouldn't be the case when a company is retaining most of its earnings. So there might be other factors at play here which could potentially be hampering growth. For instance, the business has faced some headwinds.
Additionally, Graham Holdings 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.
Summary
In total, we're a bit ambivalent about Graham Holdings' performance. While the company does have a high rate of reinvestment, the low ROE means that all that reinvestment is not reaping any benefit to its investors, and moreover, its having a negative impact on the earnings growth. Wrapping up, we would proceed with caution with this company and one way of doing that would be to look at the risk profile of the business. Our risks dashboard will have the 1 risk we have identified for Graham Holdings.
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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.
