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Could The Market Be Wrong About Nick Scali Limited (ASX:NCK) Given Its Attractive Financial Prospects?

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It is hard to get excited after looking at Nick Scali's (ASX:NCK) recent performance, when its stock has declined 24% over the past three months. But if you pay close attention, you might gather that its strong financials could mean that the stock could potentially see an increase in value in the long-term, given how markets usually reward companies with good financial health. Specifically, we decided to study Nick Scali's ROE in this article.

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

View our latest analysis for Nick Scali

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 Nick Scali is:

61% = AU$77m ÷ AU$126m (Based on the trailing twelve months to December 2021).

The 'return' refers to a company's earnings over the last year. That means that for every A$1 worth of shareholders' equity, the company generated A$0.61 in profit.

What Is The Relationship Between ROE And Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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 everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.

Nick Scali's Earnings Growth And 61% ROE

Firstly, we acknowledge that Nick Scali has a significantly high ROE. Second, a comparison with the average ROE reported by the industry of 21% also doesn't go unnoticed by us. This likely paved the way for the modest 18% net income growth seen by Nick Scali over the past five years. growth

As a next step, we compared Nick Scali's net income growth with the industry and found that the company has a similar growth figure when compared with the industry average growth rate of 18% in the same period.

past-earnings-growth
past-earnings-growth

Earnings growth is a huge factor in stock valuation. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. One good indicator of expected earnings growth is the P/E ratio which determines the price the market is willing to pay for a stock based on its earnings prospects. So, you may want to check if Nick Scali is trading on a high P/E or a low P/E, relative to its industry.

Is Nick Scali Efficiently Re-investing Its Profits?

The high three-year median payout ratio of 87% (or a retention ratio of 13%) for Nick Scali suggests that the company's growth wasn't really hampered despite it returning most of its income to its shareholders.

Besides, Nick Scali has been paying dividends for at least ten years or more. This shows that the company is committed to sharing profits with its shareholders. Based on the latest analysts' estimates, we found that the company's future payout ratio over the next three years is expected to hold steady at 81%. Accordingly, forecasts suggest that Nick Scali's future ROE will be 50% which is again, similar to the current ROE.

Conclusion

In total, we are pretty happy with Nick Scali's performance. Especially the high ROE, Which has contributed to the impressive growth seen in earnings. Despite the company reinvesting only a small portion of its profits, it still has managed to grow its earnings so that is appreciable. Having said that, the company's earnings growth is expected to slow down, as forecasted in the current analyst estimates. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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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