With its stock down 17% over the past three months, it is easy to disregard Fevertree Drinks (LON:FEVR). But if you pay close attention, you might gather that its strong financials could mean that the stock could potentially see an increase in value in the long-term, given how markets usually reward companies with good financial health. In this article, we decided to focus on Fevertree Drinks' ROE.
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.
How Do You Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Fevertree Drinks is:
16% = UK£45m ÷ UK£282m (Based on the trailing twelve months to December 2021).
The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each £1 of shareholders' capital it has, the company made £0.16 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. 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 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.
Fevertree Drinks' Earnings Growth And 16% ROE
To begin with, Fevertree Drinks seems to have a respectable ROE. Even when compared to the industry average of 14% the company's ROE looks quite decent. Despite the modest returns, Fevertree Drinks' five year net income growth was quite low, averaging at only 2.8%. We reckon that a low growth, when returns are moderate could be the result of certain circumstances like low earnings retention or poor allocation of capital.
When you consider the fact that the industry earnings have shrunk at a rate of 0.1% in the same period, the company's net income growth is pretty remarkable.
Earnings growth is an important metric to consider when valuing a stock. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is FEVR fairly valued? This infographic on the company's intrinsic value has everything you need to know.
Is Fevertree Drinks Using Its Retained Earnings Effectively?
Despite having a moderate three-year median payout ratio of 37% (implying that the company retains the remaining 63% of its income), Fevertree Drinks' earnings growth was quite low. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.
In addition, Fevertree Drinks has been paying dividends over a period of seven years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 39% of its profits over the next three years. Still, forecasts suggest that Fevertree Drinks' future ROE will rise to 22% even though the the company's payout ratio is not expected to change by much.
In total, we are pretty happy with Fevertree Drinks' performance. Particularly, we like that the company is reinvesting heavily into its business, and at a high rate of return. Unsurprisingly, this has led to an impressive earnings growth. Having said that, looking at the current analyst estimates, we found that the company's earnings are expected to gain momentum. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts 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.