Alphabet (NASDAQ:GOOGL) has had a rough three months with its share price down 6.3%. But if you pay close attention, you might gather that its strong financials could mean that the stock could potentially see an increase in value in the long-term, given how markets usually reward companies with good financial health. Particularly, we will be paying attention to Alphabet’s ROE today.
Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
View our latest analysis for Alphabet
How Do You Calculate Return On Equity?
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 Alphabet is:
29% = US$88b ÷ US$301b (Based on the trailing twelve months to June 2024).
The ‘return’ is the amount earned after tax over the last twelve months. That means that for every $1 worth of shareholders’ equity, the company generated $0.29 in profit.
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. 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.
A Side By Side comparison of Alphabet’s Earnings Growth And 29% ROE
To begin with, Alphabet has a pretty high ROE which is interesting. Secondly, even when compared to the industry average of 7.1% the company’s ROE is quite impressive. This likely paved the way for the modest 18% net income growth seen by Alphabet over the past five years.
We then compared Alphabet’s net income growth with the industry and we’re pleased to see that the company’s growth figure is higher when compared with the industry which has a growth rate of 8.0% in the same 5-year period.
Earnings growth is a huge factor in stock valuation. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. Doing so will help them establish if the stock’s future looks promising or ominous. Has the market priced in the future outlook for GOOGL? You can find out in our latest intrinsic value infographic research report.
Is Alphabet Efficiently Re-investing Its Profits?
Alphabet has a low three-year median payout ratio of 2.8%, meaning that the company retains the remaining 97% of its profits. This suggests that the management is reinvesting most of the profits to grow the business.
Upon studying the latest analysts’ consensus data, we found that the company’s future payout ratio is expected to rise to 10% over the next three years. Accordingly, the expected increase in the payout ratio explains the expected decline in the company’s ROE to 21%, over the same period.
Summary
On the whole, we feel that Alphabet’s performance has been quite good. In particular, it’s great to see that the company is investing heavily into its business and along with a high rate of return, that has resulted in a sizeable growth in its earnings. 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.
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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.
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