Three Squirrels (SZSE:300783) has had a rough week with its share price down 5.5%. It is possible that the markets have ignored the company's differing financials and decided to lean-in to the negative sentiment. Fundamentals usually dictate market outcomes so it makes sense to study the company's financials. Specifically, we decided to study Three Squirrels' 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 short, ROE shows the profit each dollar generates with respect to its shareholder investments.

How Do You Calculate Return On Equity?

The formula for ROE is:

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

So, based on the above formula, the ROE for Three Squirrels is:

8.4% = CN¥205m ÷ CN¥2.5b (Based on the trailing twelve months to September 2023).

The 'return' is the amount earned after tax over the last twelve months. So, this means that for every CN¥1 of its shareholder's investments, the company generates a profit of CN¥0.08.

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. 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.

Three Squirrels' Earnings Growth And 8.4% ROE

On the face of it, Three Squirrels' ROE is not much to talk about. Yet, a closer study shows that the company's ROE is similar to the industry average of 8.5%. But then again, Three Squirrels' five year net income shrunk at a rate of 11%. Remember, the company's ROE is a bit low to begin with. Hence, this goes some way in explaining the shrinking earnings.

That being said, we compared Three Squirrels' 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 7.3% in the same 5-year period.

Earnings growth is an important metric to consider when valuing a stock. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is Three Squirrels fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Three Squirrels Efficiently Re-investing Its Profits?

In spite of a normal three-year median payout ratio of 34% (that is, a retention ratio of 66%), the fact that Three Squirrels' 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.

Additionally, Three Squirrels has paid dividends over a period of four years, which means that the company's management is rather focused on keeping up its dividend payments, regardless of the shrinking earnings.

Conclusion

In total, we're a bit ambivalent about Three Squirrels' performance. 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.