It is hard to get excited after looking at Cato's (NYSE:CATO) recent performance, when its stock has declined 5.7% over the past week. We, however decided to study the company's financials to determine if they have got anything to do with the price decline. 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. In this article, we decided to focus on Cato's ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

Check out our latest analysis for Cato

How Is ROE Calculated?

The formula for return on equity is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Cato is:

3.9% = US$9.6m ÷ US$246m (Based on the trailing twelve months to July 2022).

The 'return' is the profit over the last twelve months. That means that for every $1 worth of shareholders' equity, the company generated $0.04 in profit.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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 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.

Cato's Earnings Growth And 3.9% ROE

It is quite clear that Cato's ROE is rather low. Even when compared to the industry average of 31%, the ROE figure is pretty disappointing. Therefore, it might not be wrong to say that the five year net income decline of 7.0% seen by Cato was possibly a result of it having a lower ROE. However, there could also be other factors causing the earnings to decline. Such as - low earnings retention or poor allocation of capital.

However, when we compared Cato's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 31% in the same period. This is quite worrisome.

Earnings growth is a huge factor in stock valuation. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. Doing so will help them establish if the stock's future looks promising or ominous. If you're wondering about Cato's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Cato Using Its Retained Earnings Effectively?

Cato's low three-year median payout ratio of 18% (implying that it retains the remaining 82% of its profits) comes as a surprise when you pair it with the shrinking earnings. The low payout should mean that the company is retaining most of its earnings and consequently, should see some growth. It looks like there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.

In addition, Cato has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth.

Conclusion

In total, we're a bit ambivalent about Cato's performance. While the company does have a high rate of profit retention, its low rate of return is probably hampering its earnings growth. Wrapping up, we would proceed with caution with this company and one way of doing that would be to look at the risk profile of the business. To know the 3 risks we have identified for Cato visit our risks dashboard for free.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.

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