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With its stock down 11% over the past three months, it is easy to disregard A. O. Smith (NYSE:AOS). However, a closer look at its sound financials might cause you to think again. Given that fundamentals usually drive long-term market outcomes, the company is worth looking at. Specifically, we decided to study A. O. Smith's ROE in this article.
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 A. O. Smith
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 A. O. Smith is:
29% = US$561m ÷ US$1.9b (Based on the trailing twelve months to September 2024).
The 'return' is the yearly profit. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.29 in profit.
Why Is ROE Important For Earnings Growth?
Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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. O. Smith's Earnings Growth And 29% ROE
First thing first, we like that A. O. Smith has an impressive ROE. Secondly, even when compared to the industry average of 18% the company's ROE is quite impressive. This likely paved the way for the modest 7.0% net income growth seen by A. O. Smith over the past five years.
We then compared A. O. Smith's net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 16% in the same 5-year period, which is a bit concerning.
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. This then helps them determine if the stock is placed for a bright or bleak future. Is AOS fairly valued? This infographic on the company's intrinsic value has everything you need to know.
Is A. O. Smith Efficiently Re-investing Its Profits?
With a three-year median payout ratio of 35% (implying that the company retains 65% of its profits), it seems that A. O. Smith is reinvesting efficiently in a way that it sees respectable amount growth in its earnings and pays a dividend that's well covered.