Most readers would already be aware that Toll Brothers' (NYSE:TOL) stock increased significantly by 11% over the past week. Given the company's impressive performance, we decided to study its financial indicators more closely as a company's financial health over the long-term usually dictates market outcomes. Specifically, we decided to study Toll Brothers' ROE in this article.

ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

How To Calculate Return On Equity?

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 Toll Brothers is:

22% = US$1.6b ÷ US$7.3b (Based on the trailing twelve months to April 2024).

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 $0.22.

What Is The Relationship Between ROE And Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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.

Toll Brothers' Earnings Growth And 22% ROE

To begin with, Toll Brothers seems to have a respectable ROE. Especially when compared to the industry average of 15% the company's ROE looks pretty impressive. This probably laid the ground for Toll Brothers' significant 25% net income growth seen over the past five years. However, there could also be other causes behind this growth. For instance, the company has a low payout ratio or is being managed efficiently.

As a next step, we compared Toll Brothers' net income growth with the industry and found that the company has a similar growth figure when compared with the industry average growth rate of 24% in the same period.

Earnings growth is an important metric to consider when valuing a stock. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. 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 Toll Brothers is trading on a high P/E or a low P/E, relative to its industry.

Is Toll Brothers Efficiently Re-investing Its Profits?

Toll Brothers has a really low three-year median payout ratio of 7.0%, meaning that it has the remaining 93% left over to reinvest into its business. This suggests that the management is reinvesting most of the profits to grow the business as evidenced by the growth seen by the company.

Moreover, Toll Brothers is determined to keep sharing its profits with shareholders which we infer from its long history of seven years of paying a dividend. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 6.3%. However, Toll Brothers' future ROE is expected to decline to 16% despite there being not much change anticipated in the company's payout ratio.

Conclusion

In total, we are pretty happy with Toll Brothers' 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. Having said that, on studying current analyst estimates, we were concerned to see that while the company has grown its earnings in the past, analysts expect its earnings to shrink in the future. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com