a2 Milk's (NZSE:ATM) stock is up by a considerable 46% over the past three months. Given that stock prices are usually aligned with a company's financial performance in the long-term, we decided to study its financial indicators more closely to see if they had a hand to play in the recent price move. Specifically, we decided to study a2 Milk's ROE in this article.

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.

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How Is ROE Calculated?

Return on equity 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 a2 Milk is:

12% = NZ$159m ÷ NZ$1.4b (Based on the trailing twelve months to December 2024).

The 'return' is the profit 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$0.12 in profit.

See our latest analysis for a2 Milk

What Has ROE Got To Do With Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don’t share these attributes.

a2 Milk's Earnings Growth And 12% ROE

To begin with, a2 Milk seems to have a respectable ROE. On comparing with the average industry ROE of 6.8% the company's ROE looks pretty remarkable. Needless to say, we are quite surprised to see that a2 Milk's net income shrunk at a rate of 18% over the past five years. Based on this, we feel that there might be other reasons which haven't been discussed so far in this article that could be hampering the company's growth. These include low earnings retention or poor allocation of capital.

Furthermore, even when compared to the industry, which has been shrinking its earnings at a rate of 7.3% over the last few years, we found that a2 Milk's performance is pretty disappointing, as it suggests that the company has been shrunk its earnings at a rate faster than the industry.

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. Doing so will help them establish if the stock's future looks promising or ominous. What is ATM worth today? The intrinsic value infographic in our free research report helps visualize whether ATM is currently mispriced by the market.

Is a2 Milk Using Its Retained Earnings Effectively?

Looking at its three-year median payout ratio of 27% (or a retention ratio of 73%) which is pretty normal, a2 Milk's declining earnings is rather baffling as one would expect to see a fair bit of growth when a company is retaining a good portion of its profits. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.

Looking at the current analyst consensus data, we can see that the company's future payout ratio is expected to rise to 72% over the next three years. Still, forecasts suggest that a2 Milk's future ROE will rise to 16% even though the the company's payout ratio is expected to rise. We presume that there could some other characteristics of the business that could be driving the anticipated growth in the company's ROE.

Conclusion

In total, it does look like a2 Milk has some positive aspects to its business. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE and and a high reinvestment rate. We believe that there might be some outside factors that could be having a negative impact on the business. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.

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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.