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WPP plc's (LON:WPP) Stock Is Going Strong: Have Financials A Role To Play?

Most readers would already be aware that WPP's (LON:WPP) stock increased significantly by 20% over the past three months. We wonder if and what role the company's financials play in that price change as a company's long-term fundamentals usually dictate market outcomes. Particularly, we will be paying attention to WPP'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 short, ROE shows the profit each dollar generates with respect to its shareholder investments.

See our latest analysis for WPP

How Is ROE Calculated?

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 WPP is:

8.4% = UK£707m ÷ UK£8.4b (Based on the trailing twelve months to December 2019).

The 'return' refers to a company's earnings over the last year. That means that for every £1 worth of shareholders' equity, the company generated £0.08 in profit.

Why Is ROE Important For Earnings Growth?

So far, we've learnt 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.

WPP's Earnings Growth And 8.4% ROE

At first glance, WPP's ROE doesn't look very promising. Although a closer study shows that the company's ROE is higher than the industry average of 6.7% which we definitely can't overlook. Having said that, WPP's net income growth over the past five years is more or less flat. Remember, the company's ROE is a bit low to begin with, just that it is higher than the industry average. Hence, this goes some way in explaining the flat earnings growth.

Next, on comparing with the industry net income growth, we found that the industry grew its earnings by17% in the same period.

LSE:WPP Past Earnings Growth July 2nd 2020
LSE:WPP Past Earnings Growth July 2nd 2020

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). Doing so will help them establish if the stock's future looks promising or ominous. Is WPP fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is WPP Efficiently Re-investing Its Profits?

In spite of a normal three-year median payout ratio of 47% (or a retention ratio of 53%), WPP hasn't seen much growth in its earnings. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.

Looking at the current analyst consensus data, we can see that the company's future payout ratio is expected to rise to 58% over the next three years. However, WPP's 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

Overall, we feel that WPP certainly does have some positive factors to consider. Although, we are disappointed to see a lack of growth in earnings even in spite of a moderate ROE and and a high reinvestment rate. We believe that there might be some outside factors that could be having a negative impact on the business. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.

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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