It is hard to get excited after looking at Park Aerospace's (NYSE:PKE) recent performance, when its stock has declined 23% over the past three months. It is possible that the markets have ignored the company's differing financials and decided to lean-in to the negative sentiment. Stock prices are usually driven by a company’s financial performance over the long term, and therefore we decided to pay more attention to the company's financial performance. Specifically, we decided to study Park Aerospace's ROE in this article.
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
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 Park Aerospace is:
7.2% = US$10m ÷ US$142m (Based on the trailing twelve months to March 2020).
The 'return' is the amount earned after tax over the last twelve months. That means that for every $1 worth of shareholders' equity, the company generated $0.07 in profit.
Why Is ROE Important For Earnings Growth?
Thus far, we have learnt 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 Park Aerospace's Earnings Growth And 7.2% ROE
At first glance, Park Aerospace's ROE doesn't look very promising. A quick further study shows that the company's ROE doesn't compare favorably to the industry average of 13% either. Given the circumstances, the significant decline in net income by 10% seen by Park Aerospace over the last five years is not surprising. However, there could also be other factors causing the earnings to decline. For example, it is possible that the business has allocated capital poorly or that the company has a very high payout ratio.
However, when we compared Park Aerospace's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 14% in the same period. This is quite worrisome.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. Doing so will help them establish if the stock's future looks promising or ominous. If you're wondering about Park Aerospace's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.
Is Park Aerospace Using Its Retained Earnings Effectively?
Looking at its three-year median payout ratio of 47% (or a retention ratio of 53%) which is pretty normal, Park Aerospace's declining earnings is rather baffling as one would expect to see a fair bit of growth when a company is retaining a good portion of its profits. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.
Moreover, Park Aerospace has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over earnings growth.
On the whole, we feel that the performance shown by Park Aerospace can be open to many interpretations. While the company does have a high rate of reinvestment, the low ROE means that all that reinvestment is not reaping any benefit to its investors, and moreover, its having a negative impact on the earnings growth. Wrapping up, we would proceed with caution with this company and one way of doing that would be to look at the risk profile of the business. You can see the 4 risks we have identified for Park Aerospace by visiting our risks dashboard for free on our platform here.
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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. Thank you for reading.