Will Weakness in Harvey Norman Holdings Limited's (ASX:HVN) Stock Prove Temporary Given Strong Fundamentals?

With its stock down 32% over the past three months, it is easy to disregard Harvey Norman Holdings (ASX:HVN). 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. Specifically, we decided to study Harvey Norman Holdings' 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 other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

See our latest analysis for Harvey Norman Holdings

How Is ROE Calculated?

The formula for ROE is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Harvey Norman Holdings is:

20% = AU$816m ÷ AU$4.2b (Based on the trailing twelve months to December 2021).

The 'return' is the yearly profit. One way to conceptualize this is that for each A$1 of shareholders' capital it has, the company made A$0.20 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. 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.

Harvey Norman Holdings' Earnings Growth And 20% ROE

At first glance, Harvey Norman Holdings seems to have a decent ROE. And on comparing with the industry, we found that the the average industry ROE is similar at 20%. This certainly adds some context to Harvey Norman Holdings' moderate 17% net income growth seen over the past five years.

Given that the industry shrunk its earnings at a rate of 0.5% in the same period, the net income growth of the company is quite impressive.

Earnings growth is a huge factor in stock valuation. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. 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 Harvey Norman Holdings is trading on a high P/E or a low P/E, relative to its industry.

Is Harvey Norman Holdings Efficiently Re-investing Its Profits?

The high three-year median payout ratio of 64% (or a retention ratio of 36%) for Harvey Norman Holdings suggests that the company's growth wasn't really hampered despite it returning most of its income to its shareholders.

Moreover, Harvey Norman Holdings is determined to keep sharing its profits with shareholders which we infer from its long history of paying a dividend for at least ten years. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 75%. However, Harvey Norman Holdings' future ROE is expected to decline to 12% despite there being not much change anticipated in the company's payout ratio.

Conclusion

On the whole, we feel that Harvey Norman Holdings' performance has been quite good. Especially the high ROE, Which has contributed to the impressive growth seen in earnings. Despite the company reinvesting only a small portion of its profits, it still has managed to grow its earnings so that is appreciable. That being so, according to the latest industry analyst forecasts, the company's earnings are expected to shrink in the future. 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.