Linamar's (TSE:LNR) stock is up by a considerable 29% over the past three months. Given that stock prices are usually aligned with a company's financial performance in the long-term, we decided to study its financial indicators more closely to see if they had a hand to play in the recent price move. In this article, we decided to focus on Linamar's ROE.
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?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Linamar is:
7.8% = CA$360m ÷ CA$4.6b (Based on the trailing twelve months to June 2022).
The 'return' refers to a company's earnings over the last year. Another way to think of that is that for every CA$1 worth of equity, the company was able to earn CA$0.08 in profit.
Why Is ROE Important For 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. 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.
Linamar's Earnings Growth And 7.8% ROE
When you first look at it, Linamar's ROE doesn't look that attractive. Although a closer study shows that the company's ROE is higher than the industry average of 6.4% which we definitely can't overlook. However, Linamar's five year net income decline rate was 11%. Bear in mind, the company does have a slightly low ROE. It is just that the industry ROE is lower. Hence, this goes some way in explaining the shrinking earnings.
Next, on comparing with the industry net income growth, we found that Linamar's earnings seems to be shrinking at a similar rate as the industry which shrunk at a rate of a 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). Doing so will help them establish if the stock's future looks promising or ominous. Is Linamar fairly valued compared to other companies? These 3 valuation measures might help you decide.
Is Linamar Efficiently Re-investing Its Profits?
Linamar's low three-year median payout ratio of 9.3% (or a retention ratio of 91%) over the last three years should mean that the company is retaining most of its earnings to fuel its growth but the company's earnings have actually shrunk. This typically shouldn't be the case when a company is retaining most of its earnings. So there might be other factors at play here which could potentially be hampering growth. For instance, the business has faced some headwinds.
Additionally, Linamar has paid dividends over a period of at least ten years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth.
Overall, we feel that Linamar certainly does have some positive factors to consider. Yet, the low earnings growth is a bit concerning, especially given that the company has a respectable rate of return and is reinvesting a huge portion of its profits. By the looks of it, there could be some other factors, not necessarily in control of the business, that's preventing growth. While we won't completely dismiss the company, what we would do, is try to ascertain how risky the business is to make a more informed decision around the company. Our risks dashboard would have the 3 risks we have identified for Linamar.
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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.
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