It is hard to get excited after looking at Universal's (NYSE:UVV) recent performance, when its stock has declined 3.9% over the past month. It is possible that the markets have ignored the company's differing financials and decided to lean-in to the negative sentiment. Stock prices are usually driven by a company’s financial performance over the long term, and therefore we decided to pay more attention to the company's financial performance. Particularly, we will be paying attention to Universal's ROE today.
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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.
How To Calculate Return On Equity?
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 Universal is:
7.5% = US$104m ÷ US$1.4b (Based on the trailing twelve months to March 2022).
The 'return' is the yearly profit. That means that for every $1 worth of shareholders' equity, the company generated $0.07 in profit.
What Has ROE Got To Do With Earnings Growth?
We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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.
Universal's Earnings Growth And 7.5% ROE
When you first look at it, Universal'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 21%. However, the moderate 8.7% net income growth seen by Universal over the past five years is definitely a positive. So, the growth in the company's earnings could probably have been caused by other variables. Such as - high earnings retention or an efficient management in place.
As a next step, we compared Universal's net income growth with the industry and were disappointed to see that the company's growth is lower than the industry average growth of 11% in the same period.
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. 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 Universal is trading on a high P/E or a low P/E, relative to its industry.
Is Universal Using Its Retained Earnings Effectively?
The high three-year median payout ratio of 87% (or a retention ratio of 13%) for Universal suggests that the company's growth wasn't really hampered despite it returning most of its income to its shareholders.
Besides, Universal has been paying dividends for at least ten years or more. This shows that the company is committed to sharing profits with its shareholders.
On the whole, we feel that the performance shown by Universal can be open to many interpretations. While no doubt its earnings growth is pretty respectable, the low profit retention could mean that the company's earnings growth could have been higher, had it been paying reinvesting a higher portion of its profits. An improvement in its ROE could also help future earnings growth. So far, we've only made a quick discussion around the company's earnings growth. So it may be worth checking this free detailed graph of Universal's past earnings, as well as revenue and cash flows to get a deeper insight into the company's performance.
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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.