It is hard to get excited after looking at Automatic Data Processing's (NASDAQ:ADP) recent performance, when its stock has declined 12% over the past month. However, a closer look at its sound financials might cause you to think again. Given that fundamentals usually drive long-term market outcomes, the company is worth looking at. Particularly, we will be paying attention to Automatic Data Processing's ROE today.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.
How Do You Calculate Return On Equity?
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 Automatic Data Processing is:
43% = US$2.5b ÷ US$5.8b (Based on the trailing twelve months to June 2020).
The 'return' is the yearly profit. That means that for every $1 worth of shareholders' equity, the company generated $0.43 in profit.
What Is The Relationship Between ROE And Earnings Growth?
Thus far, we have learned that ROE measures how efficiently a company is generating its profits. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. 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 Automatic Data Processing's Earnings Growth And 43% ROE
Firstly, we acknowledge that Automatic Data Processing has a significantly high ROE. Second, a comparison with the average ROE reported by the industry of 16% also doesn't go unnoticed by us. Probably as a result of this, Automatic Data Processing was able to see a decent net income growth of 12% over the last five years.
Next, on comparing Automatic Data Processing's net income growth with the industry, we found that the company's reported growth is similar to the industry average growth rate of 11% in the same period.
Earnings growth is an important metric to consider when valuing a stock. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). This then helps them determine if the stock is placed for a bright or bleak future. Is ADP fairly valued? This infographic on the company's intrinsic value has everything you need to know.
Is Automatic Data Processing Efficiently Re-investing Its Profits?
While Automatic Data Processing has a three-year median payout ratio of 58% (which means it retains 42% of profits), the company has still seen a fair bit of earnings growth in the past, meaning that its high payout ratio hasn't hampered its ability to grow.
Additionally, Automatic Data Processing has paid dividends over a period of at least ten years which means that the company is pretty serious about sharing its profits with shareholders. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 60%. As a result, Automatic Data Processing's ROE is not expected to change by much either, which we inferred from the analyst estimate of 51% for future ROE.
Overall, we are quite pleased with Automatic Data Processing's performance. Especially the high ROE, Which has contributed to the impressive growth seen in earnings. Despite the company reinvesting only a small portion of its profits, it still has managed to grow its earnings so that is appreciable. With that said, the latest industry analyst forecasts reveal that the company's earnings growth is expected to slow down. 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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