Loews (NYSE:L) has had a rough month with its share price down 9.3%. However, stock prices are usually driven by a company’s financials over the long term, which in this case look pretty respectable. Particularly, we will be paying attention to Loews’ ROE today.
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. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company’s shareholders.
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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 Loews is:
10% = US$1.8b ÷ US$18b (Based on the trailing twelve months to March 2022).
The ‘return’ refers to a company’s earnings over the last year. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.10 in profit.
Why Is ROE Important For 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.
Loews’ Earnings Growth And 10% ROE
To start with, Loews’ ROE looks acceptable. And on comparing with the industry, we found that the average industry ROE is similar at 12%. For this reason, Loews’ five year net income decline of 7.3% raises the question as to why the decent ROE didn’t translate into growth. We reckon that there could be some other factors at play here that are preventing the company’s growth. These include low earnings retention or poor allocation of capital.
So, as a next step, we compared Loews’ performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 14% in the same period.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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 awaits. If you’re wondering about Loews’s valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.
Is Loews Using Its Retained Earnings Effectively?
Loews’ low three-year median payout ratio of 4.1% (implying that it retains the remaining 96% of its profits) comes as a surprise when you pair it with the shrinking earnings. This typically shouldn’t be the case when a company is retaining most of its earnings. So there could be some other explanations in that regard. For example, the company’s business may be deteriorating.
Moreover, Loews has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over earnings growth.
In total, it does look like Loews has some positive aspects to its business. However, given the high ROE and high profit retention, we would expect the company to be delivering strong earnings growth, but that isn’t the case here. This suggests that there might be some external threat to the business, that’s hampering its growth. While we won’t completely dismiss the company, what we would do, is try to ascertain how risky the business is to make a more informed decision around the company. Our risks dashboard would have the 2 risks we have identified for Loews.
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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.