Most readers would already be aware that Tamawood's (ASX:TWD) stock increased significantly by 15% over the past three months. However, we decided to pay attention to the company's fundamentals which don't appear to give a clear sign about the company's financial health. Specifically, we decided to study Tamawood'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 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 Tamawood

How Do You 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 Tamawood is:

17% = AU$5.5m ÷ AU$33m (Based on the trailing twelve months to June 2024).

The 'return' refers to a company's earnings over the last year. Another way to think of that is that for every A$1 worth of equity, the company was able to earn A$0.17 in profit.

What Has ROE Got To Do With 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. 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.

Tamawood's Earnings Growth And 17% ROE

At first glance, Tamawood seems to have a decent ROE. Even when compared to the industry average of 14% the company's ROE looks quite decent. As you might expect, the 3.5% net income decline reported by Tamawood is a bit of a surprise. So, there might be some other aspects that could explain this. For example, it could be that the company has a high payout ratio or the business has allocated capital poorly, for instance.

As a next step, we compared Tamawood's performance with the industry and discovered the industry has shrunk at a rate of 5.0% in the same period meaning that the company has been shrinking its earnings at a rate lower than the industry. While this is not particularly good, its not particularly bad either.

Earnings growth is a huge factor in stock valuation. 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. Is Tamawood fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Tamawood Using Its Retained Earnings Effectively?

Tamawood's very high three-year median payout ratio of 214% over the last three years suggests that the company is paying its shareholders more than what it is earning and this explains the company's shrinking earnings. Its usually very hard to sustain dividend payments that are higher than reported profits. Our risks dashboard should have the 4 risks we have identified for Tamawood.

Additionally, Tamawood has paid dividends over a period of at least ten years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth.

Conclusion

On the whole, we feel that the performance shown by Tamawood can be open to many interpretations. Despite the high ROE, the company has a disappointing earnings growth number, due to its poor rate of reinvestment into its business. So far, we've only made a quick discussion around the company's earnings growth. You can do your own research on Tamawood and see how it has performed in the past by looking at this FREE detailed graph of past earnings, revenue and cash flows.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.