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Paychex (NASDAQ:PAYX) has had a rough three months with its share price down 4.6%. However, the company's fundamentals look pretty decent, and long-term financials are usually aligned with future market price movements. Particularly, we will be paying attention to Paychex'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. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
How To 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 Paychex is:
41% = US$1.3b ÷ US$3.1b (Based on the trailing twelve months to November 2021).
The 'return' is the amount earned after tax over the last twelve months. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.41 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. 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 everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.
Paychex's Earnings Growth And 41% ROE
To begin with, Paychex has a pretty high ROE which is interesting. Additionally, the company's ROE is higher compared to the industry average of 17% which is quite remarkable. This likely paved the way for the modest 7.8% net income growth seen by Paychex over the past five years. growth
As a next step, we compared Paychex'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 17% 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. Doing so will help them establish if the stock's future looks promising or ominous. What is PAYX worth today? The intrinsic value infographic in our free research report helps visualize whether PAYX is currently mispriced by the market.
Is Paychex Using Its Retained Earnings Effectively?
The high three-year median payout ratio of 80% (or a retention ratio of 20%) for Paychex suggests that the company's growth wasn't really hampered despite it returning most of its income to its shareholders.
Moreover, Paychex is determined to keep sharing its profits with shareholders which we infer from its long history of paying a dividend for at least ten years. 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 75%. Accordingly, forecasts suggest that Paychex's future ROE will be 42% which is again, similar to the current ROE.
Overall, we feel that Paychex certainly does have some positive factors to consider. Its earnings have grown respectably as we saw earlier, which was likely due to the company reinvesting its earnings at a pretty high rate of return. However, given the high ROE, we do think that the company is reinvesting a small portion of its profits. This could likely be preventing the company from growing to its full extent. The latest industry analyst forecasts show that the company is expected to maintain its current growth rate. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.