It’s hard to get excited after seeing the recent performance of Lovisa Holdings (ASX:LOV), when its shares are down 26% in the last three months. It seems that the market may have completely ignored the positive aspects of the company’s fundamentals and decided to evaluate the negative aspects more. Fundamentals often dictate market outcomes, so it makes sense to study the company’s financials. In this article, we decided to focus on the ROE of Lovisa Holdings.
Return on equity or ROE is an important factor for a shareholder to consider because it tells them how effectively their capital is reinvested. Put another way, it reveals the company’s success in turning shareholders’ investments into profits.
See our latest analysis of Lovisa Holdings
How is ROE calculated?
the formula for return on capital it is:
Return on equity = Net income (from continuing operations) ÷ Stockholders’ equity
So, based on the formula above, the ROE of Lovisa Holdings is:
66% = A$41 million ÷ A$63 million (based on the last twelve months to December 2021).
The ‘yield’ is the amount earned after tax during the last twelve months. So this means that for every Australian dollar of its shareholders’ investments, the company generates a profit of 0.66 Australian dollars.
What does ROE have to do with earnings growth?
So far, we have learned that ROE is a measure of a company’s profitability. Now we need to assess how much profit the company reinvests or “retains” for future growth, which gives us an idea about the company’s growth potential. Assuming all else remains unchanged, the higher ROE and earnings retention, the higher a company’s growth rate compared to companies that don’t necessarily have these characteristics.
A side-by-side comparison of Lovisa Holdings earnings growth and 66% ROE
First things first, we like that Lovisa Holdings has an impressive ROE. Second, even when compared to the industry average of 21%, the company’s ROE is quite impressive. For this reason, Lovisa Holdings’ 6.4% decline in net income over five years begs the question why high ROE did not translate into earnings growth. So there could be some other aspects that could explain this. For example, the company pays out a large portion of its earnings as dividends or faces competitive pressures.
However, when we compare Lovisa Holdings’ growth to the industry, we find that while the company’s earnings have shrunk, the industry has seen earnings growth of 18% over the same period. This is quite worrying.
Earnings growth is a very important factor in stock valuation. The investor should try to establish whether the expected growth or decline in earnings, whichever is the case, is discounted. By doing so, he’ll have an idea of whether the action is headed for clear blue waters or swampy waters ahead. A 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. Therefore, he may want to check if Lovisa Holdings is trading at a high P/E or a low P/E, relative to his industry.
Is Lovisa Holdings making efficient use of its profits?
With a three-year median payout ratio as high as 142%, Lovisa Holdings’ earnings decline is no surprise, as the company is paying a dividend beyond its means. Paying a dividend beyond your means is usually not viable in the long run. Our risk dashboard should have the 2 risks that we have identified for Lovisa Holdings.
Additionally, Lovisa Holdings has been paying dividends for a period of seven years, suggesting that management prefers to maintain dividend payments even though earnings have declined. Studying the most recent analyst consensus data, we find that the company’s future payout ratio is expected to fall to 72% over the next three years. As a result, the expected drop in Lovisa Holdings’ payout ratio explains the anticipated increase in the company’s future ROE to 91% over the same period.
In general, we feel that the performance shown by Lovisa Holdings may be open to many interpretations. Despite the high ROE, the company has a disappointing earnings growth figure, due to its low rate of reinvestment in its business. That being the case, the latest forecasts from industry analysts show that analysts expect to see a big improvement in the company’s earnings growth rate. To learn more about the latest analyst predictions for the company, check out this visualization of analyst forecasts for the company.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended as financial advice. It is not a recommendation to buy or sell any stock, and it does not take into account your goals or financial situation. Our goal is to provide you with long-term focused analysis driven by fundamental data. Please note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative material. Simply Wall St has no position in any of the stocks mentioned.