With its stock down 14% over the past three months, it is easy to disregard PriceSmart (NASDAQ:PSMT). However, stock prices are usually driven by a company's financials over the long term, which in this case look pretty respectable. In this article, we decided to focus on PriceSmart's ROE.

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 other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

View our latest analysis for PriceSmart

How Is ROE Calculated?

The formula for return on equity is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for PriceSmart is:

10% = US$101m ÷ US$968m (Based on the trailing twelve months to May 2022).

The 'return' is the amount earned after tax over the last twelve months. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.10 in profit.

What Is The Relationship Between ROE And 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 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.

PriceSmart's Earnings Growth And 10% ROE

To start with, PriceSmart's ROE looks acceptable. Be that as it may, the company's ROE is still quite lower than the industry average of 14%. Further, PriceSmart's five year net income growth of 4.8% is on the lower side. Not to forget, the company does have a decent ROE to begin with, just that it is lower than the industry average. So there might be other reasons for the earnings growth to be low. Such as, the company pays out a huge portion of its earnings as dividends, or is facing competitive pressures.

As a next step, we compared PriceSmart's net income growth with the industry and were disappointed to see that the company's growth is lower than the industry average growth of 8.1% in the same period.

Earnings growth is an important metric to consider when valuing a stock. 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. Is PriceSmart fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is PriceSmart Using Its Retained Earnings Effectively?

PriceSmart has a low three-year median payout ratio of 25% (meaning, the company keeps the remaining 75% of profits) which means that the company is retaining more of its earnings. This should be reflected in its earnings growth number, but that's not the case. 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, PriceSmart 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.

Conclusion

Overall, we feel that PriceSmart certainly does have some positive factors to consider. Although, we are disappointed to see a lack of growth in earnings even in spite of a moderate ROE and and a high reinvestment rate. We believe that there might be some outside factors that could be having a negative impact on the business. That being so, the latest analyst forecasts show that the company will continue to see an expansion in its earnings. 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.