Most readers would already be aware that REA Group's (ASX:REA) stock increased significantly by 25% over the past three months. However, we decided to pay attention to the company's fundamentals which don't appear to give a clear sign about the company's financial health. Specifically, we decided to study REA Group'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 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 REA Group is:
13% = AU$113m ÷ AU$864m (Based on the trailing twelve months to June 2020).
The 'return' is the income the business earned over the last year. So, this means that for every A$1 of its shareholder's investments, the company generates a profit of A$0.13.
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. 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.
A Side By Side comparison of REA Group's Earnings Growth And 13% ROE
At first glance, REA Group seems to have a decent ROE. Further, the company's ROE is similar to the industry average of 11%. For this reason, REA Group's five year net income decline of 7.4% raises the question as to why the decent ROE didn't translate into growth. 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. Such as, the company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.
That being said, we compared REA Group's performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 0.6% in the same period.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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. Is REA Group fairly valued compared to other companies? These 3 valuation measures might help you decide.
Is REA Group Using Its Retained Earnings Effectively?
REA Group's high three-year median payout ratio of 127% suggests that the company is depleting its resources to keep up its dividend payments, and this shows in its shrinking earnings. Paying a dividend higher than reported profits is not a sustainable move. Our risks dashboard should have the 2 risks we have identified for REA Group.
Additionally, REA Group has paid dividends over a period of at least ten years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 56% over the next three years. As a result, the expected drop in REA Group's payout ratio explains the anticipated rise in the company's future ROE to 35%, over the same period.
In total, we're a bit ambivalent about REA Group's performance. In spite of the high ROE, the company has failed to see growth in its earnings due to it paying out most of its profits as dividend, with almost nothing left to invest into its own business. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts 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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