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A. O. Smith's (NYSE:AOS) stock is up by a considerable 20% over the past three months. As most would know, fundamentals are what usually guide market price movements over the long-term, 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. Particularly, we will be paying attention to A. O. Smith's ROE today.
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. 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 A. O. Smith is:
19% = US$345m ÷ US$1.8b (Based on the trailing twelve months to December 2020).
The 'return' is the income the business earned over the last year. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.19.
Why Is ROE Important For Earnings Growth?
Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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. 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.
A Side By Side comparison of A. O. Smith's Earnings Growth And 19% ROE
At first glance, A. O. Smith seems to have a decent ROE. On comparing with the average industry ROE of 15% the company's ROE looks pretty remarkable. However, for some reason, the higher returns aren't reflected in A. O. Smith's meagre five year net income growth average of 3.3%. This is generally not the case as when a company has a high rate of return it should usually also have a high earnings growth rate. We reckon that a low growth, when returns are quite high could be the result of certain circumstances like low earnings retention or poor allocation of capital.
As a next step, we compared A. O. Smith's net income growth with the industry and were disappointed to see that the company's growth is lower than the industry average growth of 6.9% in the same period.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is A. O. Smith fairly valued compared to other companies? These 3 valuation measures might help you decide.
Is A. O. Smith Making Efficient Use Of Its Profits?
Despite having a moderate three-year median payout ratio of 34% (implying that the company retains the remaining 66% of its income), A. O. Smith's earnings growth was quite low. So there could be some other explanation in that regard. For instance, the company's business may be deteriorating.
In addition, A. O. Smith 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 38%. Regardless, the future ROE for A. O. Smith is predicted to rise to 25% despite there being not much change expected in its payout ratio.
In total, it does look like A. O. Smith has some positive aspects to its business. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE and and a high reinvestment rate. We believe that there might be some outside factors that could be having a negative impact on the business. That being so, the latest analyst forecasts show that the company will continue to see an expansion in its earnings. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts 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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