Hiscox's (LON:HSX) stock is up by a considerable 12% over the past month. We, however wanted to have a closer look at its key financial indicators as the markets usually pay for long-term fundamentals, and in this case, they don't look very promising. In this article, we decided to focus on Hiscox's ROE.
ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. Put another way, it reveals the company's success at turning shareholder investments into profits.
How Is ROE Calculated?
Return on equity 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 Hiscox is:
7.5% = US$190m ÷ US$2.5b (Based on the trailing twelve months to December 2021).
The 'return' is the income the business earned over the last year. Another way to think of that is that for every £1 worth of equity, the company was able to earn £0.07 in profit.
Why Is ROE Important For 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 Hiscox's Earnings Growth And 7.5% ROE
When you first look at it, Hiscox's ROE doesn't look that attractive. We then compared the company's ROE to the broader industry and were disappointed to see that the ROE is lower than the industry average of 12%. Given the circumstances, the significant decline in net income by 50% seen by Hiscox over the last five years is not surprising. We reckon that there could also be other factors at play here. Such as - low earnings retention or poor allocation of capital.
Furthermore, even when compared to the industry, which has been shrinking its earnings at a rate 6.1% in the same period, we found that Hiscox's performance is pretty disappointing, as it suggests that the company has been shrunk its earnings at a rate faster than the industry.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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 HSX fairly valued? This infographic on the company's intrinsic value has everything you need to know.
Is Hiscox Making Efficient Use Of Its Profits?
Hiscox's declining earnings is not surprising given how the company is spending most of its profits in paying dividends, judging by its three-year median payout ratio of 71% (or a retention ratio of 29%). With only a little being reinvested into the business, earnings growth would obviously be low or non-existent.
Moreover, Hiscox has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over earnings growth. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 31% over the next three years. The fact that the company's ROE is expected to rise to 14% over the same period is explained by the drop in the payout ratio.
On the whole, Hiscox's performance is quite a big let-down. As a result of its low ROE and lack of much reinvestment into the business, the company has seen a disappointing earnings growth rate. 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 company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.
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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.