It is hard to get excited after looking at British American Tobacco's (LON:BATS) recent performance, when its stock has declined 7.5% over the past three months. To decide if this trend could continue, we decided to look at its weak fundamentals as they shape the long-term market trends. Particularly, we will be paying attention to British American Tobacco's ROE today.
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 other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
How Do You Calculate Return On Equity?
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 British American Tobacco is:
7.5% = UK£5.6b ÷ UK£74b (Based on the trailing twelve months to June 2022).
The 'return' is the yearly profit. Another way to think of that is that for every £1 worth of equity, the company was able to earn £0.08 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.
British American Tobacco's Earnings Growth And 7.5% ROE
At first glance, British American Tobacco's ROE doesn't look very promising. Next, when compared to the average industry ROE of 14%, the company's ROE leaves us feeling even less enthusiastic. Given the circumstances, the significant decline in net income by 37% seen by British American Tobacco over the last five years is not surprising. We reckon that there could also be other factors at play here. For example, it is possible that the business has allocated capital poorly or that the company has a very high payout ratio.
That being said, we compared British American Tobacco's performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 8.6% in the same period.
Earnings growth is a huge factor in stock valuation. 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. Is British American Tobacco fairly valued compared to other companies? These 3 valuation measures might help you decide.
Is British American Tobacco Making Efficient Use Of Its Profits?
British American Tobacco's declining earnings is not surprising given how the company is spending most of its profits in paying dividends, judging by its three-year median payout ratio of 77% (or a retention ratio of 23%). The business is only left with a small pool of capital to reinvest - A vicious cycle that doesn't benefit the company in the long-run. Our risks dashboard should have the 3 risks we have identified for British American Tobacco.
In addition, British American Tobacco has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 63%. Regardless, the future ROE for British American Tobacco is predicted to rise to 13% despite there being not much change expected in its payout ratio.
Overall, we would be extremely cautious before making any decision on British American Tobacco. As a result of its low ROE and lack of much reinvestment into the business, the company has seen a disappointing earnings growth rate. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. 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.
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