It is hard to get excited after looking at Adacel Technologies' (ASX:ADA) recent performance, when its stock has declined 12% over the past three months. 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. In this article, we decided to focus on Adacel Technologies' ROE.
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 other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
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 Adacel Technologies is:
25% = US$3.4m ÷ US$14m (Based on the trailing twelve months to December 2021).
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$0.25.
Why Is ROE Important For Earnings Growth?
Thus far, we have learned that ROE measures how efficiently a company is generating its profits. Depending on how much of these profits the company reinvests or "retains", and how effectively it does so, we are then able to assess a company’s earnings growth potential. 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.
Adacel Technologies' Earnings Growth And 25% ROE
Firstly, we acknowledge that Adacel Technologies has a significantly high ROE. Second, a comparison with the average ROE reported by the industry of 11% also doesn't go unnoticed by us. As you might expect, the 16% net income decline reported by Adacel Technologies doesn't bode well with us. We reckon that there could be some other factors at play here that are preventing the company's growth. These include low earnings retention or poor allocation of capital.
That being said, we compared Adacel Technologies' 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.
ASX:ADA Past Earnings Growth April 16th 2022
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. One good indicator of expected earnings growth is the P/E ratio which determines the price the market is willing to pay for a stock based on its earnings prospects. So, you may want to check if Adacel Technologies is trading on a high P/E or a low P/E, relative to its industry.
Is Adacel Technologies Using Its Retained Earnings Effectively?
With a high three-year median payout ratio of 53% (implying that 47% of the profits are retained), most of Adacel Technologies' profits are being paid to shareholders, which explains the company's shrinking earnings. The business is only left with a small pool of capital to reinvest - A vicious cycle that doesn't benefit the company in the long-run. You can see the 4 risks we have identified for Adacel Technologies by visiting our risks dashboard for free on our platform here.
Additionally, Adacel Technologies has paid dividends over a period of seven years, which means that the company's management is rather focused on keeping up its dividend payments, regardless of the shrinking earnings. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to rise to 71% over the next three years. Despite the higher expected payout ratio, the company's ROE is not expected to change by much.
Summary
On the whole, we do feel that Adacel Technologies has some positive attributes. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE. Bear in mind, the company reinvests a small portion of its profits, which means that investors aren't reaping the benefits of the high rate of return. Up till now, we've only made a short study of the company's growth data. To gain further insights into Adacel Technologies' past profit growth, check out this visualization of past earnings, revenue and cash flows.
Have feedback on this article? Concerned about the content?Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.
