Xero’s (ASX:XRO) stock is up by a considerable 26% over the past three months. 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. Particularly, we will be paying attention to Xero’s ROE today.
ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. Put another way, it reveals the company’s success at turning shareholder investments into profits.
Check out our latest analysis for Xero
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 Xero is:
11% = NZ$216m ÷ NZ$1.9b (Based on the trailing twelve months to September 2024).
The ‘return’ is the income the business earned over the last year. So, this means that for every A$1 of its shareholder’s investments, the company generates a profit of A$0.11.
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.
To start with, Xero’s ROE looks acceptable. Especially when compared to the industry average of 8.0% the company’s ROE looks pretty impressive. This probably laid the ground for Xero’s significant 36% net income growth seen over the past five years. We reckon that there could also be other factors at play here. For instance, the company has a low payout ratio or is being managed efficiently.
As a next step, we compared Xero’s net income growth with the industry, and pleasingly, we found that the growth seen by the company is higher than the average industry growth of 21%.
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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. If you’re wondering about Xero’s’s valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.
