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With the stock down 6.5% over the past three months, Inchcape (LON: INCH) is easy to ignore. It seems that the market has completely ignored the positive aspects of the company’s fundamentals and has chosen to give more consideration to the negative aspects. Stock prices are usually determined by a company’s financial performance over the long term, so we decided to pay more attention to the company’s financial performance. In particular, we’re going to be paying attention to Inchcape’s ROE today.
Return on Equity, or ROE, is an important metric for assessing how efficiently a company’s management is using the company’s capital. Put simply, it measures the profitability of a company in relation to its equity.
Check out our latest analysis for Inchcape
How do you calculate the return on equity?
the Formula for return on equity is:
Return on Equity = Net Income (from continuing operations) ÷ Equity
So, based on the above formula, the ROE for Inchcape is:
6.6% = UK £ 79m £ 1.2bn (based on the last 12 months through June 2021).
“Return” refers to a company’s earnings over the past year. One way to conceptualize this is that for every £ 1 of shareholder equity the company made a profit of £ 0.07.
Why is ROE important to earnings growth?
So far we have learned that ROE is a measure of a company’s profitability. Depending on how much of these profits the company reinvests or “withholds” and how effectively this is done, we can then estimate a company’s earnings growth potential. Assuming all else is equal, companies that have both higher return on equity and higher earnings retention typically have a higher growth rate than companies that do not share the same characteristics.
Income growth and 6.6% ROE from Inchcape
At first glance, Inchcape’s ROE isn’t saying much. We then compared the company’s ROE to the broader industry and were disappointed to find that the ROE is below the industry average of 19%. Hence, it cannot be wrong to say that Inchcape’s 32% decline in net income over five years is likely due to a lower ROE. We assume that other factors could also play a role here. For example, the company has a very high payout ratio or is under competitive pressure.
Since industry profits declined 31% over the same period, we conclude that both the company and the industry are shrinking by the same amount.
Earnings growth is an important metric to consider when evaluating a stock. It is important for an investor to know whether the market has factored in the company’s expected earnings growth (or decline). This then helps them determine whether the stock is placed for a bright or bleak future. What is INCH worth today? The intrinsic value infographic in our free research report helps to visualize whether INCH is currently being mispriced by the market.
Is Inchcape Using Its Retained Profits Effectively?
Despite a normal 3-year median payout ratio of 41% (with 59% of earnings withheld), Inchcape saw earnings decline as we saw above. So other factors could play a role here that could potentially stifle growth. For example, the business has seen quite a bit of headwind.
In addition, Inchcape has been paying dividends over a period of at least a decade, suggesting that maintaining dividend payments is far more important to management, even if it comes at the expense of business growth. Our latest analyst data shows that the company’s future payout ratio is projected to be around 40% over the next three years. However, Inchcape’s ROE is forecast to rise to 20%, although the payout ratio is not expected to change.
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Overall, we believe that Inchcape’s performance can be open to many interpretations. While it may appear to be holding most of its profits, investors may not benefit from all of these reinvestments given the low ROE. The low earnings growth suggests our theory is correct. With that in mind, we’ve examined the latest analyst predictions and found that while the company has shrunk its earnings in the past, analysts expect its earnings to rise in the future. To learn more about the company’s future earnings growth projections, take a look at this for free Report on analyst forecast for the company to learn more.
This article from Simply Wall St is of a general nature. We only provide comments based on historical data and analyst projections using an unbiased methodology, and our articles are not intended as financial advice. It is not a recommendation to buy or sell stocks and does not take into account your goals or your financial situation. Our goal is to provide you with long-term, focused analysis based on fundamentals. Note that our analysis may not take into account the latest company announcements or quality material, which may be sensitive to the price. Simply Wall St has no position in any of the stocks mentioned.
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