Are Persimmon Plc’s (LON:PSN) fundamentals good enough to warrant a buy given the stock’s recent weakness?

Persimmon (LON:PSN) had a tough three months with a 25% drop in its share price. But if you pay close attention, you might find that its leading financial indicators look pretty decent, which could mean the stock could potentially rise in the long run as markets generally reward more resilient long-term fundamentals. Specifically, we decided to study Persimmon’s ROE in this article.

Return on equity or ROE is a key metric used to gauge how effectively a company’s management is using the company’s capital. In short, ROE shows the profit that each dollar generates in relation to the investments of its shareholders.

See our latest analysis for Persimmon

How to calculate return on equity?

Return on equity can be calculated using the formula:

Return on equity = Net income (from continuing operations) ÷ Equity

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

22% = £787m ÷ £3.6bn (based on trailing 12 months to December 2021).

The “yield” is the profit of the last twelve months. One way to conceptualize this is that for every pound of share capital it has, the company has made a profit of 0.22 pounds.

Why is ROE important for earnings growth?

So far we have learned that ROE is a measure of a company’s profitability. Depending on how much of those earnings the company reinvests or “keeps”, and how efficiently it does so, we are then able to gauge a company’s earnings growth potential. Generally speaking, all things being equal, companies with high return on equity and earnings retention have a higher growth rate than companies that do not share these attributes.

A side-by-side comparison of Persimmon’s earnings growth and 22% ROE

First, we recognize that Persimmon has a significantly high ROE. Second, a comparison to the average industry-reported ROE of 11% also does not go unnoticed by us. Given the circumstances, we can’t help but wonder why Persimmon has seen little to no growth over the past five years. Based on this, we believe that there might be other reasons which have not been discussed so far in this article which might hinder the growth of the business. For example, the company pays a large portion of its profits in the form of dividends or faces competitive pressures.

Given that the industry has been shrinking profits at a rate of 8.2% over the same period, the company’s net profit growth is quite impressive.

LSE: PSN Past Earnings Growth as of March 31, 2022

Earnings growth is an important metric to consider when evaluating a stock. It is important for an investor to know whether the market has priced in the expected growth (or decline) in the company’s earnings. This then helps them determine if the stock is positioned for a bright or bleak future. Is the PSN valued enough? This intrinsic business value infographic has everything you need to know.

Is Persimmon effectively using its retained earnings?

The high three-year median payout ratio of 95% (meaning the company only retains 5.4% of earnings) for Persimmon suggests the company’s earnings growth has been minimal due to the majority payout of its profits.

Additionally, Persimmon has paid dividends over a period of at least ten years, which means the company’s management is committed to paying dividends even if it means little or no earnings growth. After reviewing the latest analyst consensus data, we found that the company is expected to continue to pay out approximately 95% of its earnings over the next three years. As a result, forecasts suggest that Persimmon’s future ROE will be 21%, which is again similar to the current ROE.

Summary

Overall, we think Persimmon has positive attributes. Specifically, its high ROE which likely led to the earnings growth. Keep in mind that the company reinvests little or no earnings, which means investors don’t necessarily reap the full benefits of the high rate of return. That said, in studying the latest analyst forecasts, we found that while the company has seen growth in past earnings, analysts expect future earnings to decline, albeit slightly. Are these analyst expectations based on general industry expectations or company fundamentals? Click here to access our analyst forecast page for the company.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.

About Ian Crawford

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