Watsco (NYSE:WSO) has had a rough three months with its share price down 2.4%. However, a closer look at its sound financials might cause you to think again. Given that fundamentals usually drive long-term market outcomes, the company is worth looking at. Specifically, we decided to study Watsco's ROE in this article.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

View our latest analysis for Watsco

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 Watsco is:

20% = US$617m ÷ US$3.0b (Based on the trailing twelve months to June 2024).

The 'return' is the profit over the last twelve months. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.20.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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.

A Side By Side comparison of Watsco's Earnings Growth And 20% ROE

To begin with, Watsco seems to have a respectable ROE. On comparing with the average industry ROE of 16% the company's ROE looks pretty remarkable. Probably as a result of this, Watsco was able to see an impressive net income growth of 21% over the last 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 Watsco's net income growth with the industry and found that the company has a similar growth figure when compared with the industry average growth rate of 25% in the same period.

Earnings growth is an important metric to consider when valuing a stock. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). This then helps them determine if the stock is placed for a bright or bleak future. Is Watsco fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Watsco Making Efficient Use Of Its Profits?

The high three-year median payout ratio of 63% (implying that it keeps only 37% of profits) for Watsco suggests that the company's growth wasn't really hampered despite it returning most of the earnings to its shareholders.

Moreover, Watsco is determined to keep sharing its profits with shareholders which we infer from its long history of paying a dividend for at least ten years. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 71%. Therefore, the company's future ROE is also not expected to change by much with analysts predicting an ROE of 20%.

Summary

On the whole, we feel that Watsco's performance has been quite good. We are particularly impressed by the considerable earnings growth posted by the company, which was likely backed by its high ROE. While the company is paying out most of its earnings as dividends, it has been able to grow its earnings in spite of it, so that's probably a good sign. That being so, a study of the latest analyst forecasts show that the company is expected to see a slowdown in its future earnings growth. 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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