With its stock down 16% over the past three months, it is easy to disregard Rentokil Initial (LON:RTO). We, however decided to study the company's financials to determine if they have got anything to do with the price decline. Stock prices are usually driven by a company’s financial performance over the long term, and therefore we decided to pay more attention to the company's financial performance. In this article, we decided to focus on Rentokil Initial's ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

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How Do You Calculate Return On Equity?

The formula for return on equity is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Rentokil Initial is:

7.3% = UK£307m ÷ UK£4.2b (Based on the trailing twelve months to December 2024).

The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each £1 of shareholders' capital it has, the company made £0.07 in profit.

View our latest analysis for Rentokil Initial

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. 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 everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.

Rentokil Initial's Earnings Growth And 7.3% ROE

When you first look at it, Rentokil Initial's ROE doesn't look that attractive. Yet, a closer study shows that the company's ROE is similar to the industry average of 7.5%. On the other hand, Rentokil Initial reported a moderate 9.6% net income growth over the past five years. Considering the moderately low ROE, it is quite possible that there might be some other aspects that are positively influencing the company's earnings growth. For instance, the company has a low payout ratio or is being managed efficiently.

We then compared Rentokil Initial's net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 21% in the same 5-year period, which is a bit concerning.

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. Is Rentokil Initial fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Rentokil Initial Using Its Retained Earnings Effectively?

The high three-year median payout ratio of 58% (or a retention ratio of 42%) for Rentokil Initial suggests that the company's growth wasn't really hampered despite it returning most of its income to its shareholders.

Besides, Rentokil Initial has been paying dividends for at least ten years or more. This shows that the company is committed to sharing profits with its shareholders. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 43% over the next three years. The fact that the company's ROE is expected to rise to 13% over the same period is explained by the drop in the payout ratio.

Summary

On the whole, we feel that the performance shown by Rentokil Initial can be open to many interpretations. While the company has posted a decent earnings growth, We do feel that the earnings growth number could have been even higher, had the company been reinvesting more of its earnings at a higher rate of return. That being so, the latest analyst forecasts show that the company will continue to see an expansion in its earnings. 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.