It is hard to get excited after looking at Peet's (ASX:PPC) recent performance, when its stock has declined 12% over the past month. We, however decided to study the company's financials to determine if they have got anything to do with the price decline. Fundamentals usually dictate market outcomes so it makes sense to study the company's financials. In this article, we decided to focus on Peet's ROE.

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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

See our latest analysis for Peet

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 Peet is:

5.3% = AU$28m ÷ AU$533m (Based on the trailing twelve months to June 2021).

The 'return' is the profit over the last twelve months. So, this means that for every A$1 of its shareholder's investments, the company generates a profit of A$0.05.

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 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 Peet's Earnings Growth And 5.3% ROE

When you first look at it, Peet's ROE doesn't look that attractive. We then compared the company's ROE to the broader industry and were disappointed to see that the ROE is lower than the industry average of 7.0%. For this reason, Peet's five year net income decline of 33% 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.

Next, when we compared with the industry, which has shrunk its earnings at a rate of 5.6% in the same period, we still found Peet's performance to be quite bleak, because the company has been shrinking its earnings faster than the industry.

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. 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 Peet is trading on a high P/E or a low P/E, relative to its industry.

Is Peet Efficiently Re-investing Its Profits?

In spite of a normal three-year median payout ratio of 50% (that is, a retention ratio of 50%), the fact that Peet's earnings have shrunk is quite puzzling. So there could be some other explanations in that regard. For instance, the company's business may be deteriorating.

In addition, Peet 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.

Summary

On the whole, we feel that the performance shown by Peet can be open to many interpretations. While the company does have a high rate of reinvestment, the low ROE means that all that reinvestment is not reaping any benefit to its investors, and moreover, its having a negative impact on the earnings growth. Wrapping up, we would proceed with caution with this company and one way of doing that would be to look at the risk profile of the business. Our risks dashboard would have the 3 risks we have identified for Peet.

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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