Should Weakness in Appen Limited's (ASX:APX) Stock Be Seen As A Sign That Market Will Correct The Share Price Given Decent Financials?

By

Simply Wall St

Published

September 29, 2021

Source: Shutterstock

With its stock down 35% over the past three months, it is easy to disregard Appen (ASX:APX). But if you pay close attention, you might find that its key financial indicators look quite decent, which could mean that the stock could potentially rise in the long-term given how markets usually reward more resilient long-term fundamentals. Specifically, we decided to study Appen'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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.

See our latest analysis for Appen

How Do You Calculate Return On Equity?

The formula for ROE is:

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

So, based on the above formula, the ROE for Appen is:

8.0% = US$30m ÷ US$373m (Based on the trailing twelve months to June 2021).

The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each A$1 of shareholders' capital it has, the company made A$0.08 in profit.

Why Is ROE Important For 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 Appen's Earnings Growth And 8.0% ROE

On the face of it, Appen's ROE is not much to talk about. Yet, a closer study shows that the company's ROE is similar to the industry average of 8.0%. Particularly, the exceptional 29% net income growth seen by Appen over the past five years is pretty remarkable. Given the slightly low ROE, it is likely that there could be some other aspects that are driving this growth. Such as - high earnings retention or an efficient management in place.

Next, on comparing with the industry net income growth, we found that Appen's growth is quite high when compared to the industry average growth of 14% in the same period, which is great to see.

ASX:APX Past Earnings Growth September 29th 2021

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is APX fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is Appen Efficiently Re-investing Its Profits?

Appen's ' three-year median payout ratio is on the lower side at 24% implying that it is retaining a higher percentage (76%) of its profits. So it looks like Appen is reinvesting profits heavily to grow its business, which shows in its earnings growth.

Moreover, Appen is determined to keep sharing its profits with shareholders which we infer from its long history of six years of paying a dividend. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 24% of its profits over the next three years. However, Appen's ROE is predicted to rise to 11% despite there being no anticipated change in its payout ratio.

Summary

Overall, we feel that Appen certainly does have some positive factors to consider. Despite its low rate of return, the fact that the company reinvests a very high portion of its profits into its business, no doubt contributed to its high earnings growth. With that said, the latest industry analyst forecasts reveal that the company's earnings growth is expected to slow down.