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Textron's (NYSE:TXT) stock is up by a considerable 17% 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. Particularly, we will be paying attention to Textron'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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
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 Textron is:
5.3% = US$309m ÷ US$5.8b (Based on the trailing twelve months to January 2021).
The 'return' is the profit 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 $0.05 in profit.
What Has ROE Got To Do With Earnings Growth?
So far, we've learned that ROE is a measure of a company's profitability. 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.
A Side By Side comparison of Textron's Earnings Growth And 5.3% ROE
At first glance, Textron's ROE doesn't look very promising. Next, when compared to the average industry ROE of 8.8%, the company's ROE leaves us feeling even less enthusiastic. Given the circumstances, the significant decline in net income by 4.3% seen by Textron over the last five years is not surprising. We believe that there also might be other aspects that are negatively influencing the company's earnings prospects. For example, it is possible that the business has allocated capital poorly or that the company has a very high payout ratio.
However, when we compared Textron's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 13% in the same period. This is quite worrisome.
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. This then helps them determine if the stock is placed for a bright or bleak future. Has the market priced in the future outlook for TXT? You can find out in our latest intrinsic value infographic research report.
Is Textron Making Efficient Use Of Its Profits?
Textron's low three-year median payout ratio of 2.5% (or a retention ratio of 97%) over the last three years should mean that the company is retaining most of its earnings to fuel its growth but the company's earnings have actually shrunk. This typically shouldn't be the case when a company is retaining most of its earnings. So there might be other factors at play here which could potentially be hampering growth. For instance, the business has faced some headwinds.
Moreover, Textron 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. 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 2.1%. Regardless, the future ROE for Textron is predicted to rise to 12% despite there being not much change expected in its payout ratio.
On the whole, we feel that the performance shown by Textron can be open to many interpretations. While the company does have a high rate of reinvestment, the low ROE means that all that reinvestment is not reaping any benefit to its investors, and moreover, its having a negative impact on the earnings growth. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. 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.
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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