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It is hard to get excited after looking at British American Tobacco's (LON:BATS) recent performance, when its stock has declined 6.6% over the past three months. 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 British American Tobacco's ROE today.
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
How To Calculate Return On Equity?
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 British American Tobacco is:
10% = UK£6.4b ÷ UK£63b (Based on the trailing twelve months to June 2021).
The 'return' is the yearly profit. Another way to think of that is that for every £1 worth of equity, the company was able to earn £0.10 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. Depending on how much of these profits the company reinvests or "retains", and how effectively it does so, we are then able to assess a company’s earnings growth potential. 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.
A Side By Side comparison of British American Tobacco's Earnings Growth And 10% ROE
To begin with, British American Tobacco seems to have a respectable ROE. Further, the company's ROE is similar to the industry average of 10%. However, while British American Tobacco has a pretty respectable ROE, its five year net income decline rate was 13% . Based on this, we feel that there might be other reasons which haven't been discussed so far in this article that could be hampering the company's growth. These include low earnings retention or poor allocation of capital.
However, when we compared British American Tobacco's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 7.0% in the same period. This is quite worrisome.
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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is British American Tobacco fairly valued compared to other companies? These 3 valuation measures might help you decide.
Is British American Tobacco Using Its Retained Earnings Effectively?
British American Tobacco has a high three-year median payout ratio of 75% (that is, it is retaining 25% of its profits). This suggests that the company is paying most of its profits as dividends to its shareholders. This goes some way in explaining why its earnings have been shrinking. The business is only left with a small pool of capital to reinvest - A vicious cycle that doesn't benefit the company in the long-run. You can see the 2 risks we have identified for British American Tobacco by visiting our risks dashboard for free on our platform here.
Additionally, British American Tobacco 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. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 61% of its profits over the next three years. Regardless, the future ROE for British American Tobacco is predicted to rise to 12% despite there being not much change expected in its payout ratio.
In total, it does look like British American Tobacco has some positive aspects to its business. Yet, the low earnings growth is a bit concerning, especially given that the company has a high rate of return. Investors could have benefitted from the high ROE, had the company been reinvesting more of its earnings. As discussed earlier, the company is retaining a small portion of its profits. That being so, the latest industry analyst forecasts show that the analysts are expecting to see a huge improvement in the company's earnings growth rate. 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.
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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