Most readers would already be aware that Telecom Plus' (LON:TEP) stock increased significantly by 28% over the past three months. However, we decided to pay attention to the company's fundamentals which don't appear to give a clear sign about the company's financial health. In this article, we decided to focus on Telecom Plus' ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

See our latest analysis for Telecom Plus

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 Telecom Plus is:

15% = UK£30m ÷ UK£204m (Based on the trailing twelve months to September 2021).

The 'return' is the amount earned after tax over the last twelve months. So, this means that for every £1 of its shareholder's investments, the company generates a profit of £0.15.

What Is The Relationship Between ROE And Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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.

Telecom Plus' Earnings Growth And 15% ROE

To begin with, Telecom Plus seems to have a respectable ROE. On comparing with the average industry ROE of 12% the company's ROE looks pretty remarkable. Despite this, Telecom Plus' five year net income growth was quite low averaging at only 3.0%. This is generally not the case as when a company has a high rate of return it should usually also have a high earnings growth rate. A few likely reasons why this could happen is that the company could have a high payout ratio or the business has allocated capital poorly, for instance.

As a next step, we compared Telecom Plus' net income growth with the industry and were disappointed to see that the company's growth is lower than the industry average growth of 4.2% in the same period.

Earnings growth is an important metric to consider when valuing a stock. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). Doing so will help them establish if the stock's future looks promising or ominous. Is TEP fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is Telecom Plus Efficiently Re-investing Its Profits?

Telecom Plus' very high three-year median payout ratio of 125% suggests that the company is paying its shareholders more than what it is earning and it definitely contributes to the low earnings growth seen by the company. This is quite a risky position to be in. To know the 2 risks we have identified for Telecom Plus visit our risks dashboard for free.

In addition, Telecom Plus has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 90% over the next three years. Still forecasts suggest that Telecom Plus' future ROE will drop to 5.6% even though the the company's payout ratio is expected to decrease. This suggests that there could be other factors could driving the anticipated decline in the company's ROE.

Conclusion

Overall, we have mixed feelings about Telecom Plus. Despite the high ROE, the company has a disappointing earnings growth number, due to its poor rate of reinvestment into its business. With that said, the latest industry analyst forecasts reveal that the company's earnings are expected to accelerate. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.

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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.