Most readers would already be aware that HealthStream's (NASDAQ:HSTM) stock increased significantly by 16% over the past three months. But the company's key financial indicators appear to be differing across the board and that makes us question whether or not the company's current share price momentum can be maintained. Specifically, we decided to study HealthStream's ROE in this article.
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. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.
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 HealthStream is:
3.8% = US$13m ÷ US$342m (Based on the trailing twelve months to September 2023).
The 'return' refers to a company's earnings over the last year. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.04 in profit.
What Is The Relationship Between ROE And 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.
HealthStream's Earnings Growth And 3.8% ROE
It is hard to argue that HealthStream's ROE is much good in and of itself. Even when compared to the industry average of 7.8%, the ROE figure is pretty disappointing. Given the circumstances, the significant decline in net income by 8.6% seen by HealthStream over the last five years is not surprising. However, there could also be other factors causing the earnings to decline. Such as - low earnings retention or poor allocation of capital.
However, when we compared HealthStream's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 1.8% in the same period. This is quite worrisome.
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). By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is HSTM fairly valued? This infographic on the company's intrinsic value has everything you need to know.
Is HealthStream Using Its Retained Earnings Effectively?
When we piece together HealthStream's low three-year median payout ratio of 12% (where it is retaining 88% of its profits), calculated for the last three-year period, we are puzzled by the lack of growth. The low payout should mean that the company is retaining most of its earnings and consequently, should see some growth. It looks like there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.
Additionally, HealthStream started paying a dividend only recently. So it looks like the management may have perceived that shareholders favor dividends even though earnings have been in decline. Our latest analyst data shows that the future payout ratio of the company is expected to rise to 19% over the next three years.
On the whole, we feel that the performance shown by HealthStream can be open to many interpretations. While the company does have a high rate of profit retention, its low rate of return is probably hampering its 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.
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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.