Should Weakness in Countplus Limited's (ASX:CUP) Stock Be Seen As A Sign That Market Will Correct The Share Price Given Decent Financials?

Countplus (ASX:CUP) has had a rough month with its share price down 2.2%. However, the company's fundamentals look pretty decent, and long-term financials are usually aligned with future market price movements. Specifically, we decided to study Countplus' 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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.

View our latest analysis for Countplus

How Do You Calculate Return On Equity?

Return on equity 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 Countplus is:

18% = AU$14m ÷ AU$75m (Based on the trailing twelve months to December 2019).

The 'return' refers to a company's earnings over the last year. So, this means that for every A$1 of its shareholder's investments, the company generates a profit of A$0.18.

What Has ROE Got To Do With 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. 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.

Countplus' Earnings Growth And 18% ROE

At first glance, Countplus seems to have a decent ROE. Even when compared to the industry average of 16% the company's ROE looks quite decent. As you might expect, the 23% net income decline reported by Countplus is a bit of a surprise. So, there might be some other aspects that could explain this. These include low earnings retention or poor allocation of capital.

That being said, we compared Countplus' performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 18% in the same period.

Earnings growth is a huge factor in stock valuation. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). This then helps them determine if the stock is placed for a bright or bleak future. Is Countplus fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Countplus Using Its Retained Earnings Effectively?

In spite of a normal three-year median payout ratio of 39% (that is, a retention ratio of 61%), the fact that Countplus' earnings have shrunk is quite puzzling. It looks like there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.

Moreover, Countplus has been paying dividends for nine years, which is a considerable amount of time, suggesting that management must have perceived that the shareholders prefer consistent dividends even though earnings have been shrinking.

Conclusion

In total, it does look like Countplus has some positive aspects to its business. Although, we are disappointed to see a lack of growth in earnings even in spite of a high 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. You can see the 4 risks we have identified for Countplus by visiting our risks dashboard for free on our platform here.

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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