Reliance's (NYSE:RS) stock is up by a considerable 17% over the past three months. Given that the market rewards strong financials in the long-term, we wonder if that is the case in this instance. Specifically, we decided to study Reliance's ROE in this article.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors' money. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

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 Reliance is:

14% = US$1.0b ÷ US$7.4b (Based on the trailing twelve months to September 2024).

The 'return' is the yearly profit. That means that for every $1 worth of shareholders' equity, the company generated $0.14 in profit.

Why Is ROE Important For Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. 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.

Reliance's Earnings Growth And 14% ROE

To start with, Reliance's ROE looks acceptable. Especially when compared to the industry average of 11% the company's ROE looks pretty impressive. Probably as a result of this, Reliance was able to see a decent growth of 19% over the last five years.

As a next step, we compared Reliance's 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 23% 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 Reliance is trading on a high P/E or a low P/E, relative to its industry.

Is Reliance Using Its Retained Earnings Effectively?

Reliance has a low three-year median payout ratio of 15%, meaning that the company retains the remaining 85% of its profits. This suggests that the management is reinvesting most of the profits to grow the business.

Additionally, Reliance has paid dividends over a period of at least ten years which means that the company is pretty serious about sharing its profits with shareholders. Our latest analyst data shows that the future payout ratio of the company is expected to rise to 21% over the next three years. However, the company's ROE is not expected to change by much despite the higher expected payout ratio.

Conclusion

In total, we are pretty happy with Reliance's performance. In particular, it's great to see that the company is investing heavily into its business and along with a high rate of return, that has resulted in a sizeable growth in its earnings. With that said, on studying the latest analyst forecasts, we found that while the company has seen growth in its past earnings, analysts expect its future earnings to shrink. 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.