RLI (NYSE:RLI) has had a great run on the share market with its stock up by a significant 11% over the last month. However, we decided to pay attention to the company’s fundamentals which don’t appear to give a clear sign about the company’s financial health. In this article, we decided to focus on RLI’s ROE.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company’s shareholders.
See our latest analysis for RLI
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 RLI is:
7.1% = US$65m ÷ US$916m (Based on the trailing twelve months to March 2020).
The ‘return’ is the amount earned after tax over the last twelve months. So, this means that for every $1 of its shareholder’s investments, the company generates a profit of $0.07.
Why Is ROE Important For Earnings Growth?
Thus far, we have learnt 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. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don’t share these attributes.
RLI’s Earnings Growth And 7.1% ROE
When you first look at it, RLI’s ROE doesn’t look that attractive. A quick further study shows that the company’s ROE doesn’t compare favorably to the industry average of 8.9% either. For this reason, RLI’s five year net income decline of 4.0% is not surprising given its lower ROE. However, there could also be other factors causing the earnings to decline. For instance, the company has a very high payout ratio, or is faced with competitive pressures.
However, when we compared RLI’s growth with the industry we found that while the company’s earnings have been shrinking, the industry has seen an earnings growth of 7.8% in the same period. This is quite worrisome.
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. Is RLI fairly valued compared to other companies? These 3 valuation measures might help you decide.
Is RLI Efficiently Re-investing Its Profits?
Looking at its three-year median payout ratio of 27% (or a retention ratio of 73%) which is pretty normal, RLI’s declining earnings is rather baffling as one would expect to see a fair bit of growth when a company is retaining a good portion of its profits. So there could be some other explanations in that regard. For instance, the company’s business may be deteriorating.
Additionally, RLI has paid dividends over a period of at least ten years, which means that the company’s management is determined to pay dividends even if it means little to no earnings growth.
On the whole, we feel that the performance shown by RLI can be open to many interpretations. 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. 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. 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. Thank you for reading.