It is hard to get excited after looking at TPG Telecom's (ASX:TPG) recent performance, when its stock has declined 19% over the past three months. However, the company's fundamentals look pretty decent, and long-term financials are usually aligned with future market price movements. Particularly, we will be paying attention to TPG Telecom's ROE today.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
How Is ROE Calculated?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for TPG Telecom is:
6.2% = AU$734m ÷ AU$12b (Based on the trailing twelve months to December 2020).
The 'return' is the amount earned after tax over the last twelve months. Another way to think of that is that for every A$1 worth of equity, the company was able to earn A$0.06 in profit.
Why Is ROE Important For Earnings Growth?
So far, we've learned that ROE is a measure of a company's profitability. 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 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.
TPG Telecom's Earnings Growth And 6.2% ROE
At first glance, TPG Telecom's ROE doesn't look very promising. A quick further study shows that the company's ROE doesn't compare favorably to the industry average of 10% either. Despite this, surprisingly, TPG Telecom saw an exceptional 45% net income growth over the past five years. Therefore, there could be other reasons behind this growth. Such as - high earnings retention or an efficient management in place.
As a next step, we compared TPG Telecom's net income growth with the industry, and pleasingly, we found that the growth seen by the company is higher than the average industry growth of 11%.
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. Doing so will help them establish if the stock's future looks promising or ominous. 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 TPG Telecom is trading on a high P/E or a low P/E, relative to its industry.
Is TPG Telecom Making Efficient Use Of Its Profits?
TPG Telecom's three-year median payout ratio to shareholders is 12%, which is quite low. This implies that the company is retaining 88% of its profits. So it seems like the management is reinvesting profits heavily to grow its business and this reflects in its earnings growth number.
Our latest analyst data shows that the future payout ratio of the company is expected to rise to 73% over the next three years. Consequently, the higher expected payout ratio explains the decline in the company's expected ROE (to 4.3%) over the same period.
Overall, we feel that TPG Telecom certainly does have some positive factors to consider. Even in spite of the low rate of return, the company has posted impressive earnings growth as a result of reinvesting heavily into its business. That being so, according to the latest industry analyst forecasts, the company's earnings are expected to shrink in the future. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.
This article by Simply Wall St is general in nature. 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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