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A. O. Smith (NYSE:AOS) has had a rough month with its share price down 9.5%. However, stock prices are usually driven by a company’s financials over the long term, which in this case look pretty respectable. Specifically, we decided to study A. O. Smith's ROE in this article.
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. Put another way, it reveals the company's success at turning shareholder investments into profits.
View our latest analysis for A. O. Smith
How To 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 A. O. Smith is:
24% = US$441m ÷ US$1.8b (Based on the trailing twelve months to June 2021).
The 'return' refers to a company's earnings over the last year. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.24 in profit.
What Is The Relationship Between ROE And Earnings Growth?
Thus far, we have learned that ROE measures how efficiently a company is generating its profits. Depending on how much of these profits the company reinvests or "retains", and how effectively it does so, we are then able to assess a company’s earnings growth potential. 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 A. O. Smith's Earnings Growth And 24% ROE
Firstly, we acknowledge that A. O. Smith has a significantly high ROE. Second, a comparison with the average ROE reported by the industry of 17% also doesn't go unnoticed by us. Yet, A. O. Smith has posted measly growth of 3.4% over the past five years. This is interesting as the high returns should mean that the company has the ability to generate high growth but for some reason, it hasn't been able to do so. A few likely reasons why this could happen is that the company could have a high payout ratio or the business has allocated capital poorly, for instance.
As a next step, we compared A. O. Smith's net income growth with the industry and were disappointed to see that the company's growth is lower than the industry average growth of 9.1% in the same period.
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. Has the market priced in the future outlook for AOS? You can find out in our latest intrinsic value infographic research report.