Most readers would already be aware that Mitchell Services' (ASX:MSV) stock increased significantly by 20% over the past month. Given that stock prices are usually aligned with a company's financial performance in the long-term, we decided to study its financial indicators more closely to see if they had a hand to play in the recent price move. Specifically, we decided to study Mitchell Services' 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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.

View our latest analysis for Mitchell Services

How Do You 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 Mitchell Services is:

18% = AU$12m ÷ AU$65m (Based on the trailing twelve months to December 2023).

The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each A$1 of shareholders' capital it has, the company made A$0.18 in profit.

Why Is ROE Important For Earnings Growth?

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

Mitchell Services' Earnings Growth And 18% ROE

To start with, Mitchell Services' ROE looks acceptable. Especially when compared to the industry average of 10% the company's ROE looks pretty impressive. Needless to say, we are quite surprised to see that Mitchell Services' net income shrunk at a rate of 27% over the past five years. We reckon that there could be some other factors at play here that are preventing the company's growth. For example, it could be that the company has a high payout ratio or the business has allocated capital poorly, for instance.

However, when we compared Mitchell Services' growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 20% in the same period. This is quite worrisome.

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). Doing so will help them establish if the stock's future looks promising or ominous. Is Mitchell Services fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Mitchell Services Efficiently Re-investing Its Profits?

With a high three-year median payout ratio of 69% (implying that 31% of the profits are retained), most of Mitchell Services' profits are being paid to shareholders, which explains the company's shrinking earnings. With only very little left to reinvest into the business, growth in earnings is far from likely. To know the 4 risks we have identified for Mitchell Services visit our risks dashboard for free.

In addition, Mitchell Services only recently started paying a dividend so the management probably decided the shareholders prefer dividends even though earnings have been shrinking. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to rise to 112% over the next three years. Accordingly, the expected increase in the payout ratio explains the expected decline in the company's ROE to 11%, over the same period.

Conclusion

In total, it does look like Mitchell Services has some positive aspects to its business. Yet, the low earnings growth is a bit concerning, especially given that the company has a high rate of return. Investors could have benefitted from the high ROE, had the company been reinvesting more of its earnings. As discussed earlier, the company is retaining a small portion of its profits. Having said that, we studied the latest analyst forecasts, and found that analysts are expecting the company's earnings growth to improve slightly. This could offer some relief to the company's existing shareholders. 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.

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