With its stock down 6.6% over the past three months, it is easy to disregard Prudential (LON:PRU). To decide if this trend could continue, we decided to look at its weak fundamentals as they shape the long-term market trends. In this article, we decided to focus on Prudential's ROE.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
How Is ROE Calculated?
ROE 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 Prudential is:
6.9% = US$1.3b ÷ US$19b (Based on the trailing twelve months to June 2020).
The 'return' is the income the business earned over the last year. Another way to think of that is that for every £1 worth of equity, the company was able to earn £0.07 in profit.
Why Is ROE Important For 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.
A Side By Side comparison of Prudential's Earnings Growth And 6.9% ROE
At first glance, Prudential's ROE doesn't look very promising. A quick further study shows that the company's ROE doesn't compare favorably to the industry average of 12% either. Given the circumstances, the significant decline in net income by 12% seen by Prudential over the last five years is not surprising. We reckon that there could also be other factors at play here. Such as - low earnings retention or poor allocation of capital.
That being said, we compared Prudential'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 12% in the same period.
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. Has the market priced in the future outlook for PRU? You can find out in our latest intrinsic value infographic research report.
Is Prudential Efficiently Re-investing Its Profits?
With a high three-year median payout ratio of 57% (implying that 43% of the profits are retained), most of Prudential's profits are being paid to shareholders, which explains the company's shrinking earnings. With only a little being reinvested into the business, earnings growth would obviously be low or non-existent. You can see the 2 risks we have identified for Prudential by visiting our risks dashboard for free on our platform here.
Moreover, Prudential 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. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 10% over the next three years. As a result, the expected drop in Prudential's payout ratio explains the anticipated rise in the company's future ROE to 18%, over the same period.
In total, we would have a hard think before deciding on any investment action concerning Prudential. As a result of its low ROE and lack of mich reinvestment into the business, the company has seen a disappointing earnings growth rate. 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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