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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.