With its stock down 34% over the past three months, it is easy to disregard Applied Materials (NASDAQ:AMAT). However, stock prices are usually driven by a company’s financial performance over the long term, which in this case looks quite promising. Particularly, we will be paying attention to Applied Materials' 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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.
How Is ROE Calculated?
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 Applied Materials is:
58% = US$6.8b ÷ US$12b (Based on the trailing twelve months to May 2022).
The 'return' is the income the business earned over the last year. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.58.
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. 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.
Applied Materials' Earnings Growth And 58% ROE
Firstly, we acknowledge that Applied Materials has a significantly high ROE. Secondly, even when compared to the industry average of 19% the company's ROE is quite impressive. This probably laid the groundwork for Applied Materials' moderate 16% net income growth seen over the past five years.
Next, on comparing with the industry net income growth, we found that Applied Materials' reported growth was lower than the industry growth of 24% in the same period, which is not something we like to see.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). Doing so will help them establish if the stock's future looks promising or ominous. If you're wondering about Applied Materials''s valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.
Is Applied Materials Using Its Retained Earnings Effectively?
In Applied Materials' case, its respectable earnings growth can probably be explained by its low three-year median payout ratio of 21% (or a retention ratio of 79%), which suggests that the company is investing most of its profits to grow its business.
Moreover, Applied Materials 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. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 13% over the next three years. However, the company's ROE is not expected to change by much despite the lower expected payout ratio.
Overall, we are quite pleased with Applied Materials' performance. Particularly, we like that the company is reinvesting heavily into its business, and at a high rate of return. As a result, the decent growth in its earnings is not surprising. With that said, the latest industry analyst forecasts reveal that the company's earnings growth is expected to slow down. 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.