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Open Text's (NASDAQ:OTEX) stock is up by 4.1% over the past three months. However, in this article, we decided to focus on its weak financials, as long-term fundamentals ultimately dictate market outcomes. Particularly, we will be paying attention to Open Text's ROE today.
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?
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 Open Text is:
2.3% = US$90m ÷ US$4.0b (Based on the trailing twelve months to December 2020).
The 'return' is the yearly profit. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.02 in profit.
What Is The Relationship Between ROE And Earnings Growth?
So far, we've learned that ROE is a measure of a company's profitability. 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.
Open Text's Earnings Growth And 2.3% ROE
It is quite clear that Open Text's ROE is rather low. Not just that, even compared to the industry average of 14%, the company's ROE is entirely unremarkable. Given the circumstances, the significant decline in net income by 24% seen by Open Text over the last five years is not surprising. However, there could also be other factors causing the earnings to decline. For instance, the company has a very high payout ratio, or is faced with competitive pressures.
So, as a next step, we compared Open Text's 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 30% in the same period.
Earnings growth is an important metric to consider when valuing a stock. 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. What is OTEX worth today? The intrinsic value infographic in our free research report helps visualize whether OTEX is currently mispriced by the market.
Is Open Text Making Efficient Use Of Its Profits?
Open Text has a high three-year median payout ratio of 62% (that is, it is retaining 38% of its profits). This suggests that the company is paying most of its profits as dividends to its shareholders. This goes some way in explaining why its earnings have been shrinking. With only very little left to reinvest into the business, growth in earnings is far from likely. You can see the 4 risks we have identified for Open Text by visiting our risks dashboard for free on our platform here.
In addition, Open Text has been paying dividends over a period of eight years suggesting that keeping up dividend payments is preferred by the management even though earnings have been in decline. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 28% over the next three years.
In total, we would have a hard think before deciding on any investment action concerning Open Text. The company has seen a lack of earnings growth as a result of retaining very little profits and whatever little it does retain, is being reinvested at a very low rate of return. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page 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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