Most readers would already be aware that Telit Communications' (LON:TCM) stock increased significantly by 24% over the past month. Given that stock prices are usually aligned with a company's financial performance in the long-term, we decided to study its financial indicators more closely to see if they had a hand to play in the recent price move. In this article, we decided to focus on Telit Communications' ROE.
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
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 Telit Communications is:
35% = US$47m ÷ US$134m (Based on the trailing twelve months to December 2019).
The 'return' refers to a company's earnings over the last year. That means that for every £1 worth of shareholders' equity, the company generated £0.35 in profit.
What Has ROE Got To Do With 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 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.
A Side By Side comparison of Telit Communications' Earnings Growth And 35% ROE
First thing first, we like that Telit Communications has an impressive ROE. Second, a comparison with the average ROE reported by the industry of 17% also doesn't go unnoticed by us. For this reason, Telit Communications' five year net income decline of 15% raises the question as to why the high ROE didn't translate into earnings growth. So, there might be some other aspects that could explain this. For example, it could be that the company has a high payout ratio or the business has allocated capital poorly, for instance.
So, as a next step, we compared Telit Communications' performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 16% 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 Telit Communications is trading on a high P/E or a low P/E, relative to its industry.
Is Telit Communications Efficiently Re-investing Its Profits?
Telit Communications' 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 60% (or a retention ratio of 40%). With only very little left to reinvest into the business, growth in earnings is far from likely. You can see the 2 risks we have identified for Telit Communications by visiting our risks dashboard for free on our platform here.
In total, it does look like Telit Communications has some positive aspects to its business. However, while the company does have a high ROE, its earnings growth number is quite disappointing. This can be blamed on the fact that it reinvests only a small portion of its profits and pays out the rest as dividends. Moreover, after studying current analyst estimates, we discovered that the company's earnings are expected to continue to shrink in the future. 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.
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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