Most readers would already be aware that Arrow Home Group's (SZSE:001322) stock increased significantly by 29% over the past three months. But the company's key financial indicators appear to be differing across the board and that makes us question whether or not the company's current share price momentum can be maintained. Specifically, we decided to study Arrow Home Group's ROE in this article.

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. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

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 Arrow Home Group is:

3.4% = CN¥166m ÷ CN¥4.8b (Based on the trailing twelve months to September 2024).

The 'return' is the income the business earned over the last year. That means that for every CN¥1 worth of shareholders' equity, the company generated CN¥0.03 in profit.

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 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.

A Side By Side comparison of Arrow Home Group's Earnings Growth And 3.4% ROE

As you can see, Arrow Home Group's ROE looks pretty weak. Even when compared to the industry average of 7.5%, the ROE figure is pretty disappointing. Given the circumstances, the significant decline in net income by 15% seen by Arrow Home Group over the last five years is not surprising. However, there could also be other factors causing the earnings to decline. For example, the business has allocated capital poorly, or that the company has a very high payout ratio.

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 3.5% in the same period. This is quite worrisome.

Earnings growth is a huge factor in stock valuation. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. Doing so will help them establish if the stock's future looks promising or ominous. What is 001322 worth today? The intrinsic value infographic in our free research report helps visualize whether 001322 is currently mispriced by the market.

Is Arrow Home Group Using Its Retained Earnings Effectively?

In spite of a normal three-year median payout ratio of 37% (that is, a retention ratio of 63%), the fact that Arrow Home Group's earnings have shrunk is quite puzzling. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.

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 22% over the next three years. As a result, the expected drop in Arrow Home Group's payout ratio explains the anticipated rise in the company's future ROE to 8.6%, over the same period.

Conclusion

On the whole, we feel that the performance shown by Arrow Home Group can be open to many interpretations. Even though it appears to be retaining most of its profits, given the low ROE, investors may not be benefitting from all that reinvestment after all. The low earnings growth suggests our theory correct. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. 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.