Howden Joinery Group's (LON:HWDN) stock is up by a considerable 17% over the past 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 Howden Joinery Group's ROE.

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 other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

See our latest analysis for Howden Joinery Group

How Do You Calculate Return On Equity?

ROE can be calculated by using the formula:

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

So, based on the above formula, the ROE for Howden Joinery Group is:

20% = UK£148m ÷ UK£721m (Based on the trailing twelve months to December 2020).

The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each £1 of shareholders' capital it has, the company made £0.20 in profit.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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 everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.

A Side By Side comparison of Howden Joinery Group's Earnings Growth And 20% ROE

To begin with, Howden Joinery Group seems to have a respectable ROE. Especially when compared to the industry average of 14% the company's ROE looks pretty impressive. Needless to say, we are quite surprised to see that Howden Joinery Group's net income shrunk at a rate of 2.2% over the past five years. Therefore, there might be some other aspects that could explain this. These include low earnings retention or poor allocation of capital.

That being said, we compared Howden Joinery Group's performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 7.3% in the same period.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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. 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 Howden Joinery Group is trading on a high P/E or a low P/E, relative to its industry.