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State Auto Financial (NASDAQ:STFC) has had a great run on the share market with its stock up by a significant 24% over the last month. 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. Particularly, we will be paying attention to State Auto Financial'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?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for State Auto Financial is:
9.1% = US$87m ÷ US$960m (Based on the trailing twelve months to December 2019).
The 'return' is the income the business earned over the last year. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.09.
What Is The Relationship Between ROE And Earnings Growth?
Thus far, we have learnt 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 State Auto Financial's Earnings Growth And 9.1% ROE
When you first look at it, State Auto Financial's ROE doesn't look that attractive. However, given that the company's ROE is similar to the average industry ROE of 10%, we may spare it some thought. But State Auto Financial saw a five year net income decline of 24% over the past five years. Remember, the company's ROE is a bit low to begin with. Hence, this goes some way in explaining the shrinking earnings.
However, when we compared State Auto Financial's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 8.0% in the same period. This is quite worrisome.
Earnings growth is a huge factor in stock valuation. 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. One good indicator of expected earnings growth is the P/E ratio which determines the price the market is willing to pay for a stock based on its earnings prospects. So, you may want to check if State Auto Financial is trading on a high P/E or a low P/E, relative to its industry.
Is State Auto Financial Using Its Retained Earnings Effectively?
Despite having a normal three-year median payout ratio of 27% (where it is retaining 73% of its profits), State Auto Financial has seen a decline in earnings as we saw above. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.
Moreover, State Auto Financial 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. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 24% of its profits over the next three years. Still, forecasts suggest that State Auto Financial's future ROE will drop to 7.3% even though the the company's payout ratio is not expected to change by much.
On the whole, we feel that the performance shown by State Auto Financial can be open to many interpretations. Even though it appears to be retaining most of its profits, given the low ROE, investors may not be benefitting from all that reinvestment after all. The low earnings growth suggests our theory correct. With that said, we studied current analyst estimates and discovered that analysts expect the company's earnings growth to improve slightly. The company's existing shareholders might have some respite after all. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.
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