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G8 Education's (ASX:GEM) stock up by 8.4% over the past three months. However, its weak financial performance indicators makes us a bit doubtful if that trend could continue. Particularly, we will be paying attention to G8 Education's ROE today.
Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
View our latest analysis for G8 Education
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 G8 Education is:
4.9% = AU$43m ÷ AU$877m (Based on the trailing twelve months to June 2023).
The 'return' is the yearly profit. That means that for every A$1 worth of shareholders' equity, the company generated A$0.05 in profit.
What Is The Relationship Between ROE And Earnings Growth?
We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. 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.
A Side By Side comparison of G8 Education's Earnings Growth And 4.9% ROE
At first glance, G8 Education's ROE doesn't look very promising. However, its ROE is similar to the industry average of 4.9%, so we won't completely dismiss the company. But then again, G8 Education's five year net income shrunk at a rate of 2.3%. Remember, the company's ROE is a bit low to begin with. So that's what might be causing earnings growth to shrink.
However, when we compared G8 Education's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 18% in the same period. This is quite worrisome.
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. Doing so will help them establish if the stock's future looks promising or ominous. 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 G8 Education is trading on a high P/E or a low P/E, relative to its industry.