It’s hard to get excited when looking at the recent performance of Reckon (ASX:RKN), where the stock has fallen 3.4% over the last month. However, if you look closely, you may notice that the key financial indicators look pretty decent, which could mean the stock could potentially rise in the long term as markets typically reward more robust long-term fundamentals. In this article, we decided to focus on Reckon’s ROE.
Return on equity or ROE is an important metric used to assess how efficiently management is using the company’s capital. In simple terms, it assesses the profitability of a company in relation to its equity capital.
Check out our latest analysis for Reckon
How do you calculate return on equity?
Return on equity can be calculated using the formula:
Return on equity = net profit (from continuing operations) ÷ equity
So, based on the above formula, the ROE for Reckon is:
19% = AU$4.1m ÷ AU$22m (Based on trailing twelve months to June 2023).
The “return” is the amount earned after taxes over the last twelve months. This means that for every A$1 worth of shareholders, the company made a profit of A$0.19.
Why is ROE important for earnings growth?
So far we have learned that ROE measures how efficiently a company generates its profits. Depending on how much of these profits the company reinvests or “retains” and how effectively it does so, we can then assess a company’s earnings growth potential. In general, companies with a high return on equity and profit retention, other things being equal, have a higher growth rate than companies that do not have these characteristics.
A Side-by-Side Comparison of Reckon’s Earnings Growth and ROE of 19%
First of all, Reckon’s ROE looks acceptable. Furthermore, the company’s ROE compares quite favorably to the industry average of 9.4%. As you might expect, Reckon’s reported 8.1% drop in net income is a bit of a surprise. Based on this, we believe that there could be other reasons, not previously discussed in this article, that could hinder the company’s growth. For example, the company pays out a large portion of its profits as dividends or is under competitive pressure.
With this in mind, we compared Reckon’s performance to the industry and were concerned to find that while the company shrank its profits, the industry grew its profits by 22% over the same five-year period.
The basis for a company’s valuation depends to a large extent on earnings growth. Next, investors need to determine whether or not expected earnings growth is already built into the stock price. This then helps them determine whether the stock is suited for a bright or bleak future. A 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 might want to check whether Reckon is trading on a high P/E or low P/E relative to its industry.
Is Reckon using its retained earnings effectively?
Reckon has a high three-year average payout ratio of 80% (meaning it retains 20% of its profits). This suggests that the company distributes the majority of its profits to its shareholders as dividends. This goes some way to explaining why returns have declined. With very little left to reinvest in the company, earnings growth is far from likely. To learn more about the two risks we have identified for Reckon, visit our free risk dashboard.
Additionally, Reckon has paid dividends for at least ten years, suggesting that maintaining dividend payments is far more important to management, even if it comes at the expense of business growth. Existing analyst estimates suggest that the company’s future payout ratio is expected to fall to 47% over the next three years. The fact that the company’s ROE is expected to increase to 31% over the same period is explained by the lower payout ratio.
Overall, it looks like Reckon has some positive aspects to its business. Although the company has a high ROE, its earnings growth numbers are quite disappointing. This is because it only reinvests a small portion of its profits and pays out the rest as dividends. With this in mind, the latest industry analyst forecasts show that analysts are expecting a huge improvement in the company’s earnings growth rate. To know more about the company’s future earnings growth projections, check out here free Check out analyst forecasts for the company to find out more.
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This article from Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts using only an unbiased methodology and our articles are not intended as financial advice. It does not constitute a recommendation to buy or sell any stock and does not take into account your objectives or financial situation. Our goal is to provide you with long-term focused analysis based on fundamental data. Note that our analysis may not reflect the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.