With its stock down 6.8% over the past three months, it is easy to disregard LGI (ASX:LGI). 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 LGI'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. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

View our latest analysis for LGI

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 LGI is:

11% = AU$6.0m ÷ AU$54m (Based on the trailing twelve months to December 2024).

The 'return' is the yearly profit. That means that for every A$1 worth of shareholders' equity, the company generated A$0.11 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. 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 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.

LGI's Earnings Growth And 11% ROE

At first glance, LGI seems to have a decent ROE. And on comparing with the industry, we found that the the average industry ROE is similar at 12%. This certainly adds some context to LGI's exceptional 29% net income growth seen over the past five years. We reckon that there could also be other factors at play here. For example, it is possible that the company's management has made some good strategic decisions, or that the company has a low payout ratio.

Next, on comparing with the industry net income growth, we found that the growth figure reported by LGI compares quite favourably to the industry average, which shows a decline of 0.9% over the last few years.

Earnings growth is an important metric to consider when valuing a stock. 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. 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 LGI is trading on a high P/E or a low P/E, relative to its industry.

Is LGI Making Efficient Use Of Its Profits?

LGI's three-year median payout ratio is a pretty moderate 30%, meaning the company retains 70% of its income. This suggests that its dividend is well covered, and given the high growth we discussed above, it looks like LGI is reinvesting its earnings efficiently.

Along with seeing a growth in earnings, LGI only recently started paying dividends. Its quite possible that the company was looking to impress its shareholders. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 29% of its profits over the next three years. Still, forecasts suggest that LGI's future ROE will rise to 14% even though the the company's payout ratio is not expected to change by much.

Conclusion

Overall, we are quite pleased with LGI's performance. Specifically, we like that the company is reinvesting a huge chunk of its profits at a high rate of return. This of course has caused the company to see substantial growth in its earnings. Having said that, the company's earnings growth is expected to slow down, as forecasted in the current analyst estimates. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page for the company.

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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.