Most readers would already be aware that Constellation Software's (TSE:CSU) stock increased significantly by 24% over the past three months. Given that the market rewards strong financials in the long-term, we wonder if that is the case in this instance. In this article, we decided to focus on Constellation Software's ROE.
Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.
How Is ROE Calculated?
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 Constellation Software is:
46% = US$329m ÷ US$719m (Based on the trailing twelve months to March 2020).
The 'return' is the income the business earned over the last year. Another way to think of that is that for every CA$1 worth of equity, the company was able to earn CA$0.46 in profit.
What Is The Relationship Between ROE And Earnings Growth?
We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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. 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.
Constellation Software's Earnings Growth And 46% ROE
To begin with, Constellation Software has a pretty high ROE which is interesting. Additionally, the company's ROE is higher compared to the industry average of 21% which is quite remarkable. As a result, Constellation Software's exceptional 21% net income growth seen over the past five years, doesn't come as a surprise.
We then compared Constellation Software's net income growth with the industry and we're pleased to see that the company's growth figure is higher when compared with the industry which has a growth rate of 11% 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. 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 Constellation Software's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.
Is Constellation Software Using Its Retained Earnings Effectively?
The three-year median payout ratio for Constellation Software is 31%, which is moderately low. The company is retaining the remaining 69%. So it seems that Constellation Software is reinvesting efficiently in a way that it sees impressive growth in its earnings (discussed above) and pays a dividend that's well covered.
Besides, Constellation Software has been paying dividends for at least ten years or more. This shows that the company is committed to sharing profits with its shareholders.
On the whole, we feel that Constellation Software's performance has been quite good. Particularly, we like that the company is reinvesting heavily into its business, and at a high rate of return. Unsurprisingly, this has led to an impressive earnings growth. Having said that, the company's earnings growth is expected to slow down, as forecasted in the current analyst estimates. 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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