Lear (NYSE:LEA) has had a rough week with its share price down 2.7%. It is possible that the markets have ignored the company’s differing financials and decided to lean-in to the negative sentiment. Long-term fundamentals are usually what drive market outcomes, so it’s worth paying close attention. Particularly, we will be paying attention to Lear’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.
See our latest analysis for Lear
How Do You Calculate Return On Equity?
ROE 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 Lear is:
8.5% = US$409m ÷ US$4.8b (Based on the trailing twelve months to December 2022).
The ‘return’ is the income the business earned over the last year. That means that for every $1 worth of shareholders’ equity, the company generated $0.08 in profit.
What Is The Relationship Between ROE And 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.
Lear’s Earnings Growth And 8.5% ROE
On the face of it, Lear’s ROE is not much to talk about. Next, when compared to the average industry ROE of 14%, the company’s ROE leaves us feeling even less enthusiastic. For this reason, Lear’s five year net income decline of 38% is not surprising given its lower ROE. We reckon that there could also be other factors at play here. For example, it is possible that the business has allocated capital poorly or that the company has a very high payout ratio.
However, when we compared Lear’s growth with the industry we found that while the company’s earnings have been shrinking, the industry has seen an earnings growth of 11% in the same period. This is quite worrisome.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is LEA fairly valued? This infographic on the company’s intrinsic value has everything you need to know.
Is Lear Using Its Retained Earnings Effectively?
Looking at its three-year median payout ratio of 39% (or a retention ratio of 61%) which is pretty normal, Lear’s declining earnings is rather baffling as one would expect to see a fair bit of growth when a company is retaining a good portion of its profits. 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, Lear has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over earnings growth. Existing analyst estimates suggest that the company’s future payout ratio is expected to drop to 16% over the next three years. As a result, the expected drop in Lear’s payout ratio explains the anticipated rise in the company’s future ROE to 19%, over the same period.
Conclusion
On the whole, we feel that the performance shown by Lear can be open to many interpretations. While the company does have a high rate of profit retention, its low rate of return is probably hampering its earnings growth. Having said that, looking at current analyst estimates, we found that the company’s earnings growth rate is expected to see a huge improvement. 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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