Most readers would already be aware that Lovisa Holdings' (ASX:LOV) stock increased significantly by 40% over the past three months. Given that the market rewards strong financials in the long-term, we wonder if that is the case in this instance. In this article, we decided to focus on Lovisa Holdings' ROE.
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?
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 Lovisa Holdings is:
57% = AU$38m ÷ AU$67m (Based on the trailing twelve months to December 2019).
The 'return' is the yearly profit. One way to conceptualize this is that for each A$1 of shareholders' capital it has, the company made A$0.57 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. 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. 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.
Lovisa Holdings' Earnings Growth And 57% ROE
First thing first, we like that Lovisa Holdings has an impressive ROE. Additionally, the company's ROE is higher compared to the industry average of 16% which is quite remarkable. This probably laid the groundwork for Lovisa Holdings' moderate 15% net income growth seen over the past five years.
As a next step, we compared Lovisa Holdings' net income growth with the industry and found that the company has a similar growth figure when compared with the industry average growth rate of 14% in the same period.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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 Lovisa Holdings is trading on a high P/E or a low P/E, relative to its industry.
Is Lovisa Holdings Using Its Retained Earnings Effectively?
The high three-year median payout ratio of 79% (or a retention ratio of 21%) for Lovisa Holdings suggests that the company's growth wasn't really hampered despite it returning most of its income to its shareholders.
Additionally, Lovisa Holdings has paid dividends over a period of five years which means that the company is pretty serious about sharing its profits with shareholders. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 79%. However, Lovisa Holdings' future ROE is expected to decline to 44% despite there being not much change anticipated in the company's payout ratio.
In total, we are pretty happy with Lovisa Holdings' performance. In particular, its high ROE is quite noteworthy and also the probable explanation behind its considerable earnings growth. Yet, the company is retaining a small portion of its profits. Which means that the company has been able to grow its earnings in spite of it, so that's not too bad. With that said, the latest industry analyst forecasts reveal that the company's earnings are expected to accelerate. 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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