Ferguson (NYSE:FERG) has had a great run on the share market with its stock up by a significant 13% over the last month. 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 Ferguson'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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.

How Is ROE Calculated?

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 Ferguson is:

34% = US$1.9b ÷ US$5.5b (Based on the trailing twelve months to April 2024).

The 'return' is the income the business earned over the last year. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.34 in profit.

What Has ROE Got To Do With Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don't share these attributes.

Ferguson's Earnings Growth And 34% ROE

To begin with, Ferguson has a pretty high ROE which is interesting. Second, a comparison with the average ROE reported by the industry of 17% also doesn't go unnoticed by us. Probably as a result of this, Ferguson was able to see a decent net income growth of 16% over the last five years.

Next, on comparing with the industry net income growth, we found that Ferguson's reported growth was lower than the industry growth of 25% over the last few years, which is not something we like to see.

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). By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. 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 Ferguson is trading on a high P/E or a low P/E, relative to its industry.

Is Ferguson Using Its Retained Earnings Effectively?

With a three-year median payout ratio of 34% (implying that the company retains 66% of its profits), it seems that Ferguson is reinvesting efficiently in a way that it sees respectable amount growth in its earnings and pays a dividend that's well covered.

Additionally, Ferguson 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 over the next three years is expected to be approximately 32%. Accordingly, forecasts suggest that Ferguson's future ROE will be 29% which is again, similar to the current ROE.

Conclusion

Overall, we are quite pleased with Ferguson's 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 a good amount of growth in its earnings. Having said that, the company's earnings growth is expected to slow down, as forecasted in the current analyst estimates. 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