A. O. Smith (NYSE:AOS) has had a rough three months with its share price down 7.6%. However, stock prices are usually driven by a company's financials over the long term, which in this case look pretty respectable. Specifically, we decided to study A. O. Smith's ROE in this article.

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.

How Do You Calculate Return On Equity?

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 A. O. Smith is:

31% = US$577m ÷ US$1.9b (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 $0.31 in profit.

What Is The Relationship Between ROE And 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. 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.

A Side By Side comparison of A. O. Smith's Earnings Growth And 31% ROE

Firstly, we acknowledge that A. O. Smith has a significantly high ROE. Second, a comparison with the average ROE reported by the industry of 19% also doesn't go unnoticed by us. However, for some reason, the higher returns aren't reflected in A. O. Smith's meagre five year net income growth average of 2.3%. This is generally not the case as when a company has a high rate of return it should usually also have a high earnings growth rate. Such a scenario is likely to take place when a company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.

We then compared A. O. Smith's net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 14% in the same 5-year period, which is a bit concerning.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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. Has the market priced in the future outlook for AOS? You can find out in our latest intrinsic value infographic research report.

Is A. O. Smith Using Its Retained Earnings Effectively?

Despite having a moderate three-year median payout ratio of 36% (implying that the company retains the remaining 64% of its income), A. O. Smith's earnings growth was quite low. Therefore, there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.

Additionally, A. O. Smith 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. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 29%. As a result, A. O. Smith's ROE is not expected to change by much either, which we inferred from the analyst estimate of 30% for future ROE.

Conclusion

In total, it does look like A. O. Smith has some positive aspects to its business. Although, we are disappointed to see a lack of growth in earnings even in spite of a high 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. With that said, the latest industry analyst forecasts reveal that the company's earnings are expected to accelerate. 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.

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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.

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