It is hard to get excited after looking at Microsoft’s (NASDAQ:MSFT) recent performance, when its stock has declined 7.2% over the past three months. However, stock prices are usually driven by a company’s financial performance over the long term, which in this case looks quite promising. Specifically, we decided to study Microsoft’s ROE in this article.
Return on equity or ROE is a key measure used to assess how efficiently a company’s management is utilizing the company’s capital. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
How Is ROE Calculated?
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 Microsoft is:
40% = US$70b ÷ US$174b (Based on the trailing twelve months to September 2022).
The ‘return’ is the income the business earned over the last year. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.40 in profit.
Why Is ROE Important For Earnings Growth?
Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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. 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.
A Side By Side comparison of Microsoft’s Earnings Growth And 40% ROE
To begin with, Microsoft has a pretty high ROE which is interesting. Additionally, the company’s ROE is higher compared to the industry average of 12% which is quite remarkable. Under the circumstances, Microsoft’s considerable five year net income growth of 27% was to be expected.
We then performed a comparison between Microsoft’s net income growth with the industry, which revealed that the company’s growth is similar to the average industry growth of 24% in the same period.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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. What is MSFT worth today? The intrinsic value infographic in our free research report helps visualize whether MSFT is currently mispriced by the market.
Is Microsoft Using Its Retained Earnings Effectively?
Microsoft has a three-year median payout ratio of 30% (where it is retaining 70% of its income) which is not too low or not too high. This suggests that its dividend is well covered, and given the high growth we discussed above, it looks like Microsoft is reinvesting its earnings efficiently.
Moreover, Microsoft is determined to keep sharing its profits with shareholders which we infer from its long history of paying a dividend for at least ten years. Existing analyst estimates suggest that the company’s future payout ratio is expected to drop to 24% over the next three years. Despite the lower expected payout ratio, the company’s ROE is not expected to change by much.
In total, we are pretty happy with Microsoft’s performance. Specifically, we like that the company is reinvesting a huge chunk of its profits at a high rate of return. This of course has caused the company to see substantial growth in its earnings. That being so, a study of the latest analyst forecasts show that the company is expected to see a slowdown in its future earnings growth. 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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