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Most readers would already be aware that Pacific Smiles Group's (ASX:PSQ) stock increased significantly by 37% over the past 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. Specifically, we decided to study Pacific Smiles Group's ROE in this article.
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. Put another way, it reveals the company's success at turning shareholder investments into profits.
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 Pacific Smiles Group is:
17% = AU$6.4m ÷ AU$37m (Based on the trailing twelve months to June 2020).
The 'return' is the profit over the last twelve months. That means that for every A$1 worth of shareholders' equity, the company generated A$0.17 in profit.
What Has ROE Got To Do With 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 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 Pacific Smiles Group's Earnings Growth And 17% ROE
To begin with, Pacific Smiles Group seems to have a respectable ROE. On comparing with the average industry ROE of 8.1% the company's ROE looks pretty remarkable. Needless to say, we are quite surprised to see that Pacific Smiles Group's net income shrunk at a rate of 5.8% over the past five years. Based on this, we feel that there might be other reasons which haven't been discussed so far in this article that could be hampering the company's growth. These include low earnings retention or poor allocation of capital.
However, when we compared Pacific Smiles Group's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 3.2% in the same period. This is quite worrisome.
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. This then helps them determine if the stock is placed for a bright or bleak future. Is PSQ fairly valued? This infographic on the company's intrinsic value has everything you need to know.
Is Pacific Smiles Group Making Efficient Use Of Its Profits?
While the company did payout a portion of its dividend in the past, it currently doesn't pay a dividend. This implies that potentially all of its profits are being reinvested in the business.
Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 65% over the next three years. The fact that the company's ROE is expected to rise to 30% over the same period is explained by the drop in the payout ratio.
In total, we're a bit ambivalent about Pacific Smiles Group's performance. While the company does have a high rate of return, its low earnings retention is probably what's hampering its earnings growth. 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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