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Most readers would already know that McGrath's (ASX:MEA) stock increased by 4.2% over the past week. As most would know, long-term fundamentals have a strong correlation with market price movements, so we decided to look at the company's key financial indicators today to determine if they have any role to play in the recent price movement. In this article, we decided to focus on McGrath's ROE.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. 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 McGrath is:
26% = AU$9.8m ÷ AU$38m (Based on the trailing twelve months to December 2020).
The 'return' refers to a company's earnings over the last year. That means that for every A$1 worth of shareholders' equity, the company generated A$0.26 in profit.
What Has ROE Got To Do With Earnings Growth?
Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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. 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.
McGrath's Earnings Growth And 26% ROE
Firstly, we acknowledge that McGrath has a significantly high ROE. Additionally, the company's ROE is higher compared to the industry average of 5.1% which is quite remarkable. Needless to say, we are quite surprised to see that McGrath's net income shrunk at a rate of 15% over the past five years. We reckon that there could be some other factors at play here that are preventing the company's growth. These include low earnings retention or poor allocation of capital.
Next, when we compared with the industry, which has shrunk its earnings at a rate of 9.2% in the same period, we still found McGrath's performance to be quite bleak, because the company has been shrinking its earnings faster than the industry.
Earnings growth is a huge factor in stock valuation. 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 McGrath is trading on a high P/E or a low P/E, relative to its industry.
Is McGrath Making Efficient Use Of Its Profits?
McGrath's low three-year median payout ratio of 3.1% (implying that it retains the remaining 97% of its profits) comes as a surprise when you pair it with the shrinking earnings. The low payout should mean that the company is retaining most of its earnings and consequently, should see some growth. It looks like there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.
Additionally, McGrath has paid dividends over a period of five years, which means that the company's management is rather focused on keeping up its dividend payments, regardless of the shrinking earnings.
In total, it does look like McGrath has some positive aspects to its business. Yet, the low earnings growth is a bit concerning, especially given that the company has a high rate of return and is reinvesting ma huge portion of its profits. By the looks of it, there could be some other factors, not necessarily in control of the business, that's preventing growth. 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. Our risks dashboard would have the 3 risks we have identified for McGrath.
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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