Are Poor Financial Prospects Dragging Down Persimmon Plc (LON:PSN Stock?

Persimmon (LON:PSN) has had a rough three months with its share price down 5.3%. To decide if this trend could continue, we decided to look at its weak fundamentals as they shape the long-term market trends. In this article, we decided to focus on Persimmon'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 Persimmon

How Is ROE Calculated?

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 Persimmon is:

7.5% = UK£255m ÷ UK£3.4b (Based on the trailing twelve months to December 2023).

The 'return' refers to a company's earnings over the last year. Another way to think of that is that for every £1 worth of equity, the company was able to earn £0.07 in profit.

What Has ROE Got To Do With Earnings Growth?

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

Persimmon's Earnings Growth And 7.5% ROE

On the face of it, Persimmon's ROE is not much to talk about. Yet, a closer study shows that the company's ROE is similar to the industry average of 7.6%. But Persimmon saw a five year net income decline of 16% over the past five years. Remember, the company's ROE is a bit low to begin with. So that's what might be causing earnings growth to shrink.

Furthermore, even when compared to the industry, which has been shrinking its earnings at a rate of 3.6% over the last few years, we found that Persimmon's performance is pretty disappointing, as it suggests that the company has been shrunk its earnings at a rate faster than the industry.

Earnings growth is a huge factor in stock valuation. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). This then helps them determine if the stock is placed for a bright or bleak future. Is PSN fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is Persimmon Making Efficient Use Of Its Profits?

Persimmon's declining earnings is not surprising given how the company is spending most of its profits in paying dividends, judging by its three-year median payout ratio of 95% (or a retention ratio of 4.8%). 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. Our risks dashboard should have the 2 risks we have identified for Persimmon.

In addition, Persimmon 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. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 57% over the next three years. As a result, the expected drop in Persimmon's payout ratio explains the anticipated rise in the company's future ROE to 12%, over the same period.

Summary

On the whole, Persimmon's performance is quite a big let-down. The low ROE, combined with the fact that the company is paying out almost if not all, of its profits as dividends, has resulted in 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. 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.