City Lodge Hotels Limited's (JSE:CLH) Fundamentals Look Pretty Strong: Could The Market Be Wrong About The Stock?

It is hard to get excited after looking at City Lodge Hotels' (JSE:CLH) recent performance, when its stock has declined 21% over the past three months. However, stock prices are usually driven by a company’s financials over the long term, which in this case look pretty respectable. In this article, we decided to focus on City Lodge Hotels' ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Put another way, it reveals the company's success at turning shareholder investments into profits.

View our latest analysis for City Lodge Hotels

How Is ROE Calculated?

ROE 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 City Lodge Hotels is:

20% = R213m ÷ R1.1b (Based on the trailing twelve months to December 2022).

The 'return' refers to a company's earnings over the last year. That means that for every ZAR1 worth of shareholders' equity, the company generated ZAR0.20 in profit.

What Is The Relationship Between ROE And Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. Depending on how much of these profits the company reinvests or "retains", and how effectively it does so, we are then able to assess a company’s earnings growth potential. Assuming everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.

City Lodge Hotels' Earnings Growth And 20% ROE

At first glance, City Lodge Hotels seems to have a decent ROE. Even so, when compared with the average industry ROE of 33%, we aren't very excited. Moreover, City Lodge Hotels' net income shrunk at a rate of 33%over the past five years. Not to forget, the company does have a high ROE to begin with, just that it is lower than the industry average. Therefore, the shrinking earnings could be the result of other factors. Such as, the company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.

Furthermore, even when compared to the industry, which has been shrinking its earnings at a rate 9.4% in the same period, we found that City Lodge Hotels' performance is pretty disappointing, as it suggests that the company has been shrunk its earnings at a rate faster than the industry.

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. Doing so will help them establish if the stock's future looks promising or ominous. 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 City Lodge Hotels is trading on a high P/E or a low P/E, relative to its industry.

Is City Lodge Hotels Making Efficient Use Of Its Profits?

When we piece together City Lodge Hotels' low LTM (or last twelve month) payout ratio of 13% (where it is retaining 87% of its profits), calculated for the last three-year period, we are puzzled by the lack of growth. This typically shouldn't be the case when a company is retaining most of its earnings. So there might be other factors at play here which could potentially be hampering growth. For instance, the business has faced some headwinds.

Moreover, City Lodge Hotels 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.

Conclusion

Overall, we feel that City Lodge Hotels certainly does have some positive factors to consider. Although, we are disappointed to see a lack of growth in earnings even in spite of a moderate ROE and and a high reinvestment rate. We believe that there might be some outside factors that could be having a negative impact on the business. 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 will have the 1 risk we have identified for City Lodge Hotels.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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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