Meritage Homes (NYSE:MTH) has had a great run on the share market with its stock up by a significant 11% over the last week. Given the company's impressive performance, we decided to study its financial indicators more closely as a company's financial health over the long-term usually dictates market outcomes. In this article, we decided to focus on Meritage Homes' ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors' money. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

How Is ROE Calculated?

The formula for ROE is:

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

So, based on the above formula, the ROE for Meritage Homes is:

17% = US$793m ÷ US$4.7b (Based on the trailing twelve months to March 2024).

The 'return' is the profit over the last twelve months. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.17 in profit.

Why Is ROE Important For Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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.

Meritage Homes' Earnings Growth And 17% ROE

To start with, Meritage Homes' ROE looks acceptable. And on comparing with the industry, we found that the the average industry ROE is similar at 15%. This probably goes some way in explaining Meritage Homes' significant 27% net income growth over the past five years amongst other factors. We believe that there might also be other aspects that are positively influencing the company's earnings growth. Such as - high earnings retention or an efficient management in place.

Next, on comparing Meritage Homes' net income growth with the industry, we found that the company's reported growth is similar to the industry average growth rate of 24% over the last few years.

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). By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. One good indicator of expected earnings growth is the P/E ratio which determines the price the market is willing to pay for a stock based on its earnings prospects. So, you may want to check if Meritage Homes is trading on a high P/E or a low P/E, relative to its industry.

Is Meritage Homes Using Its Retained Earnings Effectively?

Meritage Homes' ' three-year median payout ratio is on the lower side at 3.7% implying that it is retaining a higher percentage (96%) of its profits. So it seems like the management is reinvesting profits heavily to grow its business and this reflects in its earnings growth number.

While Meritage Homes has seen growth in its earnings, it only recently started to pay a dividend. It is most likely that the company decided to impress new and existing shareholders with a dividend. Looking at the current analyst consensus data, we can see that the company's future payout ratio is expected to rise to 17% over the next three years. Consequently, the higher expected payout ratio explains the decline in the company's expected ROE (to 13%) over the same period.

Conclusion

In total, we are pretty happy with Meritage Homes' performance. Particularly, we like that the company is reinvesting heavily into its business, and at a high rate of return. Unsurprisingly, this has led to an impressive earnings growth. Having said that, on studying current analyst estimates, we were concerned to see that while the company has grown its earnings in the past, analysts expect its earnings to shrink 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.