With its stock down 3.3% over the past week, it is easy to disregard Computer Modelling Group (TSE:CMG). But if you pay close attention, you might find that its key financial indicators look quite decent, which could mean that the stock could potentially rise in the long-term given how markets usually reward more resilient long-term fundamentals. Particularly, we will be paying attention to Computer Modelling Group'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. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
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 Computer Modelling Group is:
39% = CA$20m ÷ CA$50m (Based on the trailing twelve months to December 2022).
The 'return' refers to a company's earnings over the last year. That means that for every CA$1 worth of shareholders' equity, the company generated CA$0.39 in profit.
Why Is ROE Important For Earnings Growth?
We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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.
Computer Modelling Group's Earnings Growth And 39% ROE
Firstly, we acknowledge that Computer Modelling Group has a significantly high ROE. Second, a comparison with the average ROE reported by the industry of 18% also doesn't go unnoticed by us. Needless to say, we are quite surprised to see that Computer Modelling Group's net income shrunk at a rate of 2.9% over the past five years. So, there might be some other aspects that could explain this. These include low earnings retention or poor allocation of capital.
That being said, we compared Computer Modelling Group's performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 18% in the same period.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). This then helps them determine if the stock is placed for a bright or bleak future. 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 Computer Modelling Group is trading on a high P/E or a low P/E, relative to its industry.
Is Computer Modelling Group Efficiently Re-investing Its Profits?
Computer Modelling Group has a high three-year median payout ratio of 87% (that is, it is retaining 13% 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. With only a little being reinvested into the business, earnings growth would obviously be low or non-existent. You can see the 2 risks we have identified for Computer Modelling Group by visiting our risks dashboard for free on our platform here.
In addition, Computer Modelling Group has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth.
Overall, we feel that Computer Modelling Group certainly does have some positive factors to consider. 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. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts 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.
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