Aviva plc (LON:AV.) Is Going Strong But Fundamentals Appear To Be Mixed : Is There A Clear Direction For The Stock?

Most readers would already be aware that Aviva's (LON:AV.) stock increased significantly by 8.8% over the past month. However, we decided to pay attention to the company's fundamentals which don't appear to give a clear sign about the company's financial health. Specifically, we decided to study Aviva's ROE in this article.

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 short, ROE shows the profit each dollar generates with respect to its shareholder investments.

Check out our latest analysis for Aviva

How To 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 Aviva is:

12% = UK£1.1b ÷ UK£9.6b (Based on the trailing twelve months to December 2023).

The 'return' refers to a company's earnings over the last year. So, this means that for every £1 of its shareholder's investments, the company generates a profit of £0.12.

What Has ROE Got To Do With Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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. 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.

Aviva's Earnings Growth And 12% ROE

At first glance, Aviva seems to have a decent ROE. Even so, when compared with the average industry ROE of 20%, we aren't very excited. Further research shows that Aviva's net income has shrunk at a rate of 52% over the last five years. Not to forget, the company does have a high ROE to begin with, just that it is lower than the industry average. So there might be other reasons for the earnings to shrink. These include low earnings retention or poor allocation of capital.

Next, when we compared with the industry, which has shrunk its earnings at a rate of 1.8% in the same 5-year period, we still found Aviva's performance to be quite bleak, because the company has been shrinking its earnings faster than the industry.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). This then helps them determine if the stock is placed for a bright or bleak future. Has the market priced in the future outlook for AV.? You can find out in our latest intrinsic value infographic research report.

Is Aviva Using Its Retained Earnings Effectively?

With a high three-year median payout ratio of 63% (implying that 37% of the profits are retained), most of Aviva's profits are being paid to shareholders, which explains the company's shrinking earnings. The business is only left with a small pool of capital to reinvest - A vicious cycle that doesn't benefit the company in the long-run.

In addition, Aviva 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 78% over the next three years. However, the company's ROE is not expected to change by much despite the higher expected payout ratio.

Summary

In total, we're a bit ambivalent about Aviva's performance. Primarily, we are disappointed to see a lack of growth in earnings even in spite of a moderate ROE. Bear in mind, the company reinvests a small portion of its profits, which explains the lack of growth. 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 latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.