Ethan Allen Interiors Inc.'s (NYSE:ETH) Has Been On A Rise But Financial Prospects Look Weak: Is The Stock Overpriced?

Ethan Allen Interiors' (NYSE:ETH) stock is up by a considerable 17% over the past three months. However, in this article, we decided to focus on its weak fundamentals, as long-term financial performance of a business is what ultimatley dictates market outcomes. Particularly, we will be paying attention to Ethan Allen Interiors' ROE today.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

See our latest analysis for Ethan Allen Interiors

How Do You 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 Ethan Allen Interiors is:

2.7% = US$8.9m ÷ US$328m (Based on the trailing twelve months to June 2020).

The 'return' is the profit over the last twelve months. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.03 in profit.

Why Is ROE Important For Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. 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.

Ethan Allen Interiors' Earnings Growth And 2.7% ROE

It is quite clear that Ethan Allen Interiors' ROE is rather low. Even when compared to the industry average of 14%, the ROE figure is pretty disappointing. Therefore, it might not be wrong to say that the five year net income decline of 15% seen by Ethan Allen Interiors was possibly a result of it having a lower ROE. We believe that there also might be other aspects that are negatively influencing the company's earnings prospects. For example, the business has allocated capital poorly, or that the company has a very high payout ratio.

That being said, we compared Ethan Allen Interiors' performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 18% in the same period.

Earnings growth is an important metric to consider when valuing a stock. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. This then helps them determine if the stock is placed for a bright or bleak future. One good indicator of expected earnings growth is the P/E ratio which determines the price the market is willing to pay for a stock based on its earnings prospects. So, you may want to check if Ethan Allen Interiors is trading on a high P/E or a low P/E, relative to its industry.

Is Ethan Allen Interiors Making Efficient Use Of Its Profits?

Ethan Allen Interiors' declining earnings is not surprising given how the company is spending most of its profits in paying dividends, judging by its three-year median payout ratio of 58% (or a retention ratio of 42%). With only a little being reinvested into the business, earnings growth would obviously be low or non-existent. You can see the 2 risks we have identified for Ethan Allen Interiors by visiting our risks dashboard for free on our platform here.

In addition, Ethan Allen Interiors has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Looking at the current analyst consensus data, we can see that the company's future payout ratio is expected to rise to 75% over the next three years. However, Ethan Allen Interiors' future ROE is expected to rise to 11% despite the expected increase in the company's payout ratio. We infer that there could be other factors that could be driving the anticipated growth in the company's ROE.

Summary

On the whole, Ethan Allen Interiors' performance is quite a big let-down. Because the company is not reinvesting much into the business, and given the low ROE, it's not surprising to see the lack or absence of growth in its earnings. That being so, the latest industry analyst forecasts show that the analysts are expecting to see a huge improvement in the company's earnings growth rate. 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.

This article by Simply Wall St is general in nature. 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.

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