Mercury General's (NYSE:MCY) stock is up by a considerable 36% over the past three months. However, in this article, we decided to focus on its weak fundamentals, as long-term financial performance of a business is what ultimately dictates market outcomes. Particularly, we will be paying attention to Mercury General's ROE today.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. Put another way, it reveals the company's success at turning shareholder investments into profits.

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 Mercury General is:

6.2% = US$96m ÷ US$1.5b (Based on the trailing twelve months to December 2023).

The 'return' is the yearly profit. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.06 in profit.

What Is The Relationship Between ROE And 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. 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.

Mercury General's Earnings Growth And 6.2% ROE

At first glance, Mercury General's ROE doesn't look very promising. Next, when compared to the average industry ROE of 13%, the company's ROE leaves us feeling even less enthusiastic. For this reason, Mercury General's five year net income decline of 38% is not surprising given its lower ROE. We believe that there also might be other aspects that are negatively influencing the company's earnings prospects. Such as - low earnings retention or poor allocation of capital.

That being said, we compared Mercury General's performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 8.1% in the same 5-year period.

Earnings growth is a huge factor in stock valuation. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. This then helps them determine if the stock is placed for a bright or bleak future. If you're wondering about Mercury General's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Mercury General Efficiently Re-investing Its Profits?

Mercury General's declining earnings is not surprising given how the company is spending most of its profits in paying dividends, judging by its LTM (or last twelve month) payout ratio of 73% (or a retention ratio of 27%). The business is only left with a small pool of capital to reinvest - A vicious cycle that doesn't benefit the company in the long-run.

In addition, Mercury General has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 33% over the next three years. As a result, the expected drop in Mercury General's payout ratio explains the anticipated rise in the company's future ROE to 11%, over the same period.

Summary

Overall, we would be extremely cautious before making any decision on Mercury General. Because the company is not reinvesting much into the business, and given the low ROE, it's not surprising to see the lack or absence of growth in its earnings. 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.