It is hard to get excited after looking at a2 Milk's (NZSE:ATM) recent performance, when its stock has declined 20% over the past three months. However, the company's fundamentals look pretty decent, and long-term financials are usually aligned with future market price movements. Particularly, we will be paying attention to a2 Milk'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. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

See our latest analysis for a2 Milk

How To Calculate Return On Equity?

ROE 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 a2 Milk is:

12% = NZ$154m ÷ NZ$1.3b (Based on the trailing twelve months to June 2024).

The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each NZ$1 of shareholders' capital it has, the company made NZ$0.12 in profit.

What Has ROE Got To Do With Earnings Growth?

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 everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.

a2 Milk's Earnings Growth And 12% ROE

To start with, a2 Milk's ROE looks acceptable. Even when compared to the industry average of 12% the company's ROE looks quite decent. However, while a2 Milk has a pretty respectable ROE, its five year net income decline rate was 22% . So, there might be some other aspects that could explain this. For example, it could be that the company has a high payout ratio or the business has allocated capital poorly, for instance.

Furthermore, even when compared to the industry, which has been shrinking its earnings at a rate of 5.8% over the last few years, we found that a2 Milk'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). 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 a2 Milk's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is a2 Milk Using Its Retained Earnings Effectively?

a2 Milk doesn't pay any regular dividends, meaning that potentially all of its profits are being reinvested in the business, which doesn't explain why the company's earnings have shrunk if it is retaining all of its profits. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.

Summary

In total, it does look like a2 Milk has some positive aspects to its business. However, given the high ROE and high profit retention, we would expect the company to be delivering strong earnings growth, but that isn't the case here. This suggests that there might be some external threat to the business, that's hampering its growth. 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.