Cato Corporation (NYSE:CATO) fundamentals look pretty solid: Could the market be wrong about the stock?

With its stock down 30% in the past three months, it’s easy to overlook Cato (NYSE: CATO). 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. In particular, we’ll be paying attention to Cato’s ROE today.

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 simple terms, it is used to assess the profitability of a company in relation to its equity.

See our latest analysis for Cato

How do you 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 Cato is:

10% = $26 million ÷ $251 million (based on trailing 12 months to April 2022).

The “return” is the annual profit. One way to conceptualize this is that for every $1 of share capital it has, the firm has made a profit of $0.10.

What is the relationship between ROE and earnings growth?

We have already established that ROE serves as an effective profit-generating indicator for a company’s future earnings. 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.

Cato earnings growth and ROE of 10%

For starters, Cato’s ROE looks acceptable. Still, the fact that the company’s ROE is below the industry average of 33% tempers our expectations. Additionally, Cato’s net income has declined by 11% over the past five years. Not to mention that the company has a high ROE to start with, just that it’s below the industry average. So there could be other reasons why profits are falling. For example, the company pays a large portion of its profits in the form of dividends or faces competitive pressures.

However, when we compared Cato’s growth with the industry, we found that while the company’s earnings declined, the industry saw earnings growth of 25% over the same period. It’s quite worrying.

Earnings growth is an important factor in stock valuation. What investors then need to determine is whether the expected earnings growth, or lack thereof, is already priced into the stock price. This then helps them determine if the stock is positioned for a bright or bleak future. A 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 outlook. So, you might want to check if Cato is trading on a high P/E or a low P/E, relative to its industry.

Is Cato effectively using its retained earnings?

When we piece together Cato’s low three-year median payout ratio of 18% (where it retains 82% of its earnings), calculated for the last three-year period, we are intrigued by the lack of growth. The low payout should mean that the company keeps most of its profits and therefore should see some growth. It seems that there could be other reasons for the lack in this regard. For example, the business might be in decline.

Additionally, Cato has been paying dividends for at least a decade or more, suggesting that management must have perceived that shareholders preferred dividends to earnings growth.

Summary

All in all, it looks like Cato has positives for his business. Still, the weak earnings growth is a bit of a concern, especially since the company has a respectable rate of return and reinvests a huge portion of its earnings. At first glance, there could be other factors, which do not necessarily control the business, that are preventing growth. While we wouldn’t completely dismiss the business, what we would do is try to figure out how risky the business is to make a more informed decision about the business. Our risk dashboard would have the 3 risks we identified for Cato.

Feedback on this article? Concerned about content? Get in touch with us directly. You can also email the editorial team (at) Simplywallst.com.

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.