a2 Milk (NZSE:ATM) has had a great run on the share market with its stock up by a significant 48% over the last three months. We wonder if and what role the company's financials play in that price change as a company's long-term fundamentals usually dictate market outcomes. In this article, we decided to focus on a2 Milk's 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. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

View our latest analysis for a2 Milk

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 a2 Milk is:

13% = NZ$155m ÷ NZ$1.2b (Based on the trailing twelve months to December 2023).

The 'return' is the yearly profit. That means that for every NZ$1 worth of shareholders' equity, the company generated NZ$0.13 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. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don’t share these attributes.

A Side By Side comparison of a2 Milk's Earnings Growth And 13% ROE

At first glance, a2 Milk seems to have a decent ROE. Especially when compared to the industry average of 10% the company's ROE looks pretty impressive. As you might expect, the 23% net income decline reported by a2 Milk is a bit of a surprise. We reckon that there could be some other factors at play here that are preventing the company's growth. For example, it could be that the company has a high payout ratio or the business has allocated capital poorly, for instance.

As a next step, we compared a2 Milk's performance with the industry and found thata2 Milk's performance is depressing even when compared with the industry, which has shrunk its earnings at a rate of 3.7% in the same period, which is a slower than the company.

Earnings growth is an important metric to consider when valuing a stock. 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 a2 Milk fairly valued compared to other companies? These 3 valuation measures might help you decide.