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With its stock down 21% over the past month, it is easy to disregard Inchcape (LON:INCH). But if you pay close attention, you might find that its key financial indicators look quite decent, which could mean that the stock could potentially rise in the long-term given how markets usually reward more resilient long-term fundamentals. Particularly, we will be paying attention to Inchcape's ROE today.
ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
See our latest analysis for Inchcape
How To Calculate Return On Equity?
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 Inchcape is:
15% = UK£235m ÷ UK£1.6b (Based on the trailing twelve months to December 2022).
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 £0.15 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. 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 Inchcape's Earnings Growth And 15% ROE
To begin with, Inchcape seems to have a respectable ROE. And on comparing with the industry, we found that the the average industry ROE is similar at 17%. As you might expect, the 3.6% net income decline reported by Inchcape 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. These include low earnings retention or poor allocation of capital.
However, when we compared Inchcape's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 3.7% in the same period. This is quite worrisome.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Has the market priced in the future outlook for INCH? You can find out in our latest intrinsic value infographic research report.