With its stock down 2.5% over the past month, it’s easy to overlook Telstra (ASX:TLS). But if you pay close attention, you might find that its leading financial indicators look pretty decent, which could mean the stock could potentially rise in the long run as markets generally reward more resilient long-term fundamentals. In this article, we have decided to focus on Telstra’s ROE.
ROE or return on equity is a useful tool for evaluating how effectively a company can generate returns on the investment it has received from its shareholders. In other words, it reveals the company’s success in turning shareholders’ investments into profits.
See our latest analysis for Telstra
How is ROE calculated?
ROE can be calculated using the formula:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the formula above, the ROE for Telstra is:
11% = AU$1.8 billion ÷ AU$17 billion (based on trailing 12 months to June 2022).
The “yield” is the profit of the last twelve months. This means that for every Australian dollar of equity, the company generated a profit of 0.11 Australian dollars.
Why is ROE important for earnings growth?
So far, we have learned that ROE measures how efficiently a company generates its profits. Depending on how much of those earnings the company reinvests or “keeps”, and how efficiently 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 earnings retention, the higher a company’s growth rate relative to companies that don’t necessarily exhibit these characteristics.
Telstra earnings growth and 11% ROE
For starters, Telstra seems to have a respectable ROE. Additionally, the company’s ROE compares quite favorably to the industry average of 3.2%. For this reason, Telstra’s 22% decline in net income over five years raises the question of why high ROE has not translated into profit growth. Based on this, we believe that there might be other reasons which have not been discussed so far in this article which might hinder the growth of the business. These include poor revenue retention or poor capital allocation.
However, when we compared Telstra’s growth with the industry, we found that although the company’s profits were down, the industry saw profit growth of 38% over the same period. It’s quite worrying.
Earnings growth is an important factor in stock valuation. It is important for an investor to know whether the market has priced in the expected growth (or decline) in the company’s earnings. This will help them determine if the future of the title looks bright or ominous. What is TLS worth today? The intrinsic value infographic in our free research report helps visualize whether TLS is currently being mispriced by the market.
Does Telstra effectively reinvest its profits?
Telstra has a high three-year median payout ratio of 65% (i.e. it keeps 35% of its profits). This suggests that the company pays out most of its profits in the form of dividends to its shareholders. This partly explains why his income has declined. With very little left to reinvest in the business, earnings growth is far from likely. You can see the 2 risks we have identified for Telstra by visiting our risk dashboard for free on our platform here.
Moreover, Telstra has been paying dividends for at least ten years or more, suggesting that management must have perceived that shareholders prefer dividends to earnings growth. After reviewing the latest analyst consensus data, we found that the company’s future payout ratio is expected to reach 96% over the next three years. However, Telstra’s future ROE is expected to reach 15% despite the company’s expected payout rate increase. We infer that there could be other factors that could be driving the company’s anticipated ROE growth.
Overall, we think Telstra certainly has some positives to consider. However, we are disappointed to see a lack of earnings growth, even despite high ROE. Keep in mind that the company reinvests a small portion of its profits, which means that investors do not reap the benefits of the high rate of return. That said, looking at current analyst estimates, we found that the company’s earnings growth rate should see a huge improvement. Are these analyst expectations based on general industry expectations or company fundamentals? Click here to access our analyst forecast page for the company.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.
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