With its stock down 18% over the past three months, it is easy to disregard Rakon (NZSE:RAK). But if you pay close attention, you might find that its key financial indicators look quite decent, which could mean that the stock could potentially rise in the long-term given how markets usually reward more resilient long-term fundamentals. Particularly, we will be paying attention to Rakon'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. Put another way, it reveals the company's success at turning shareholder investments into profits.
How To Calculate Return On Equity?
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 Rakon is:
5.0% = NZ$7.7m ÷ NZ$154m (Based on the trailing twelve months to September 2023).
The 'return' is the amount earned after tax over the last twelve months. One way to conceptualize this is that for each NZ$1 of shareholders' capital it has, the company made NZ$0.05 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.
Rakon's Earnings Growth And 5.0% ROE
At first glance, Rakon's ROE doesn't look very promising. We then compared the company's ROE to the broader industry and were disappointed to see that the ROE is lower than the industry average of 14%. In spite of this, Rakon was able to grow its net income considerably, at a rate of 32% in the last five years. We reckon that there could be other factors at play here. For example, it is possible that the company's management has made some good strategic decisions, or that the company has a low payout ratio.
As a next step, we compared Rakon's net income growth with the industry, and pleasingly, we found that the growth seen by the company is higher than the average industry growth of 25%.
Earnings growth is a huge factor in stock valuation. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. If you're wondering about Rakon's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.
Is Rakon Using Its Retained Earnings Effectively?
Rakon's three-year median payout ratio to shareholders is 23%, which is quite low. This implies that the company is retaining 77% of its profits. So it looks like Rakon is reinvesting profits heavily to grow its business, which shows in its earnings 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 21%. Regardless, the future ROE for Rakon is predicted to rise to 9.2% despite there being not much change expected in its payout ratio.
In total, it does look like Rakon has some positive aspects to its business. Despite its low rate of return, the fact that the company reinvests a very high portion of its profits into its business, no doubt contributed to its high earnings growth. With that said, the latest industry analyst forecasts reveal that the company's earnings are expected to accelerate. 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.
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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.