With its stock down 14% over the past three months, it is easy to disregard a2 Milk (NZSE:ATM). However, stock prices are usually driven by a company’s financials over the long term, which in this case look pretty respectable. Particularly, we will be paying attention to a2 Milk'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 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 a2 Milk is:
13% = NZ$145m ÷ NZ$1.1b (Based on the trailing twelve months to June 2023).
The 'return' refers to a company's earnings over the last year. Another way to think of that is that for every NZ$1 worth of equity, the company was able to earn NZ$0.13 in profit.
What Has ROE Got To Do With Earnings Growth?
Thus far, we have learned 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.
a2 Milk's Earnings Growth And 13% ROE
To start with, a2 Milk's ROE looks acceptable. Especially when compared to the industry average of 9.8% the company's ROE looks pretty impressive. Needless to say, we are quite surprised to see that a2 Milk's net income shrunk at a rate of 20% over the past five years. We reckon that there could be some other factors at play here that are preventing the company's growth. For example, it could be that the company has a high payout ratio or the business has allocated capital poorly, for instance.
As a next step, we compared a2 Milk's performance with the industry and found thata2 Milk's performance is depressing even when compared with the industry, which has shrunk its earnings at a rate of 3.2% in the same period, which is a slower than the company.
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. Doing so will help them establish if the stock's future looks promising or ominous. If you're wondering about a2 Milk's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.
Is a2 Milk Making Efficient Use Of Its Profits?
a2 Milk doesn't pay any dividend, meaning that the company is keeping all of its profits, which makes us wonder why it is retaining its earnings if it can't use them to grow its business. So there could be some other explanations in that regard. For instance, the company's business may be deteriorating.
In total, it does look like a2 Milk has some positive aspects to its business. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE and and a high reinvestment rate. We believe that there might be some outside factors that could be having a negative impact on the business. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. 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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.