Toll Brothers, Inc. (NYSE:TOL) Stock Has Shown Weakness Lately But Financials Look Strong: Should Prospective Shareholders Make The Leap?

Toll Brothers (NYSE:TOL) has had a rough week with its share price down 5.4%. But if you pay close attention, you might gather that its strong financials could mean that the stock could potentially see an increase in value in the long-term, given how markets usually reward companies with good financial health. Particularly, we will be paying attention to Toll Brothers' ROE today.

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

View our latest analysis for Toll Brothers

How Do You Calculate Return On Equity?

Return on equity 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 Toll Brothers is:

18% = US$982m ÷ US$5.4b (Based on the trailing twelve months to April 2022).

The 'return' is the income the business earned over the last year. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.18 in profit.

What Has ROE Got To Do With Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. Depending on how much of these profits the company reinvests or "retains", and how effectively it does so, we are then able to assess a company’s earnings growth potential. 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.

Toll Brothers' Earnings Growth And 18% ROE

To start with, Toll Brothers' ROE looks acceptable. Even when compared to the industry average of 21% the company's ROE looks quite decent. This certainly adds some context to Toll Brothers' moderate 7.2% net income growth seen over the past five years.

We then compared Toll Brothers' net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 31% in the same period, which is a bit concerning.

Earnings growth is a huge factor in stock valuation. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. Doing so will help them establish if the stock's future looks promising or ominous. 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 Toll Brothers is trading on a high P/E or a low P/E, relative to its industry.

Is Toll Brothers Making Efficient Use Of Its Profits?

In Toll Brothers' case, its respectable earnings growth can probably be explained by its low three-year median payout ratio of 11% (or a retention ratio of 89%), which suggests that the company is investing most of its profits to grow its business.

Moreover, Toll Brothers is determined to keep sharing its profits with shareholders which we infer from its long history of five years of paying a dividend. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 7.7% over the next three years. Despite the lower expected payout ratio, the company's ROE is not expected to change by much.

Summary

In total, we are pretty happy with Toll Brothers' performance. In particular, it's great to see that the company is investing heavily into its business and along with a high rate of return, that has resulted in a respectable growth in its earnings. Having said that, the company's earnings growth is expected to slow down, as forecasted in the current analyst estimates. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page 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.