Rakon (NZSE:RAK) has had a rough month with its share price down 16%. 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. In this article, we decided to focus on Rakon'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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
Check out our latest analysis for Rakon
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 Rakon is:
22% = NZ$30m ÷ NZ$140m (Based on the trailing twelve months to September 2022).
The 'return' is the amount earned after tax over the last twelve months. Another way to think of that is that for every NZ$1 worth of equity, the company was able to earn NZ$0.22 in profit.
Why Is ROE Important For Earnings Growth?
We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. 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 Rakon's Earnings Growth And 22% ROE
To start with, Rakon's ROE looks acceptable. Especially when compared to the industry average of 17% the company's ROE looks pretty impressive. Probably as a result of this, Rakon was able to see an impressive net income growth of 48% over the last five years. However, there could also be other causes behind this growth. Such as - high earnings retention or an efficient management in place.
As a next step, we compared Rakon's net income growth with the industry, and pleasingly, we found that the growth seen by the company is higher than the average industry growth of 15%.
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. 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 Rakon is trading on a high P/E or a low P/E, relative to its industry.