With its stock down 11% over the past month, it is easy to disregard Royal Mail (LON:RMG). But if you pay close attention, you might find that its key financial indicators look quite decent, which could mean that the stock could potentially rise in the long-term given how markets usually reward more resilient long-term fundamentals. Specifically, we decided to study Royal Mail's ROE in this article.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

View our latest analysis for Royal Mail

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 Royal Mail is:

13% = UK£620m ÷ UK£4.8b (Based on the trailing twelve months to March 2021).

The 'return' is the yearly profit. So, this means that for every £1 of its shareholder's investments, the company generates a profit of £0.13.

What Has ROE Got To Do With Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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. 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.

A Side By Side comparison of Royal Mail's Earnings Growth And 13% ROE

To begin with, Royal Mail seems to have a respectable ROE. Further, the company's ROE is similar to the industry average of 14%. Despite this, Royal Mail's five year net income growth was quite flat over the past five years. So, there could be some other aspects that could potentially be preventing the company from growing. These include low earnings retention or poor allocation of capital.

We then compared Royal Mail's net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 7.7% in the same period, which is a bit concerning.

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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. What is RMG worth today? The intrinsic value infographic in our free research report helps visualize whether RMG is currently mispriced by the market.

Is Royal Mail Efficiently Re-investing Its Profits?

Royal Mail has a high three-year median payout ratio of 71% (or a retention ratio of 29%), meaning that the company is paying most of its profits as dividends to its shareholders. This does go some way in explaining why there's been no growth in its earnings.

Moreover, Royal Mail has been paying dividends for seven years, which is a considerable amount of time, suggesting that management must have perceived that the shareholders prefer dividends over earnings growth. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 43% over the next three years. Despite the lower expected payout ratio, the company's ROE is not expected to change by much.

Summary

On the whole, we do feel that Royal Mail has some positive attributes. However, while the company does have a high ROE, its earnings growth number is quite disappointing. This can be blamed on the fact that it reinvests only a small portion of its profits and pays out the rest as dividends. Having said that, the company's earnings growth is expected to slow down, as forecasted in the current analyst estimates. 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.

This article by Simply Wall St is general in nature. 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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