Linamar Corporation's (TSE:LNR) Stock is Soaring But Financials Seem Inconsistent: Will The Uptrend Continue?
Linamar (TSE:LNR) has had a great run on the share market with its stock up by a significant 28% over the last three months. But the company's key financial indicators appear to be differing across the board and that makes us question whether or not the company's current share price momentum can be maintained. Particularly, we will be paying attention to Linamar's ROE today.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
See our latest analysis for Linamar
How To 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 Linamar is:
5.1% = CA$216m ÷ CA$4.2b (Based on the trailing twelve months to September 2020).
The 'return' refers to a company's earnings over the last year. So, this means that for every CA$1 of its shareholder's investments, the company generates a profit of CA$0.05.
What Is The Relationship Between ROE And Earnings Growth?
Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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. 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.
Linamar's Earnings Growth And 5.1% ROE
When you first look at it, Linamar's ROE doesn't look that attractive. Next, when compared to the average industry ROE of 9.0%, the company's ROE leaves us feeling even less enthusiastic. Given the circumstances, the significant decline in net income by 5.1% seen by Linamar over the last five years is not surprising. We reckon that there could also be other factors at play here. For example, it is possible that the business has allocated capital poorly or that the company has a very high payout ratio.
Next, we compared Linamar's performance against the industry and found that the industry shrunk its earnings at 7.9% in the same period, which suggests that the company's earnings have been shrinking at a slower rate than its industry, This does appease the negative sentiment around the company to a certain extent.
Earnings growth is a huge factor in stock valuation. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. This then helps them determine if the stock is placed for a bright or bleak future. 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 Linamar is trading on a high P/E or a low P/E, relative to its industry.
Is Linamar Efficiently Re-investing Its Profits?
Linamar's low three-year median payout ratio of 6.0% (or a retention ratio of 94%) over the last three years should mean that the company is retaining most of its earnings to fuel its growth but the company's earnings have actually shrunk. The low payout should mean that the company is retaining most of its earnings and consequently, should see some growth. So there could be some other explanations in that regard. For example, the company's business may be deteriorating.
In addition, Linamar 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. Based on the latest analysts' estimates, we found that the company's future payout ratio over the next three years is expected to hold steady at 6.8%. Still, forecasts suggest that Linamar's future ROE will rise to 9.0% even though the the company's payout ratio is not expected to change by much.
Summary
In total, we're a bit ambivalent about Linamar's performance. While the company does have a high rate of profit retention, its low rate of return is probably hampering its 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 would have the 3 risks we have identified for Linamar.
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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