Arrow Home Group (SZSE:001322) has had a rough three months with its share price down 24%. It is possible that the markets have ignored the company's differing financials and decided to lean-in to the negative sentiment. Fundamentals usually dictate market outcomes so it makes sense to study the company's financials. In this article, we decided to focus on Arrow Home Group's ROE.

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

How To Calculate Return On Equity?

The formula for ROE is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Arrow Home Group is:

6.7% = CN¥330m ÷ CN¥4.9b (Based on the trailing twelve months to March 2024).

The 'return' is the profit over the last twelve months. So, this means that for every CN¥1 of its shareholder's investments, the company generates a profit of CN¥0.07.

Why Is ROE Important For Earnings Growth?

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

Arrow Home Group's Earnings Growth And 6.7% ROE

When you first look at it, Arrow Home Group's ROE doesn't look that attractive. However, given that the company's ROE is similar to the average industry ROE of 8.3%, we may spare it some thought. But then again, Arrow Home Group's five year net income shrunk at a rate of 8.5%. Remember, the company's ROE is a bit low to begin with. So that's what might be causing earnings growth to shrink.

However, when we compared Arrow Home Group's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 4.2% 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 Arrow Home Group fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Arrow Home Group Making Efficient Use Of Its Profits?

Looking at its three-year median payout ratio of 34% (or a retention ratio of 66%) which is pretty normal, Arrow Home Group'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. So there could be some other explanations in that regard. For instance, the company's business may be deteriorating.

In addition, Arrow Home Group only recently started paying a dividend so the management probably decided the shareholders prefer dividends even though earnings have been shrinking. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 25% over the next three years. The fact that the company's ROE is expected to rise to 10% over the same period is explained by the drop in the payout ratio.

Conclusion

On the whole, we feel that the performance shown by Arrow Home Group 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. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. 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.

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