Gap (NYSE:GAP) has had a rough three months with its share price down 23%. 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. Specifically, we decided to study Gap's ROE in this article.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

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How Is ROE Calculated?

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 Gap is:

26% = US$844m ÷ US$3.3b (Based on the trailing twelve months to February 2025).

The 'return' is the amount earned after tax over the last twelve months. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.26.

See our latest analysis for Gap

Why Is ROE Important For 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.

A Side By Side comparison of Gap's Earnings Growth And 26% ROE

First thing first, we like that Gap has an impressive ROE. Second, a comparison with the average ROE reported by the industry of 18% also doesn't go unnoticed by us. Under the circumstances, Gap's considerable five year net income growth of 49% was to be expected.

Next, on comparing with the industry net income growth, we found that Gap's growth is quite high when compared to the industry average growth of 14% in the same period, which is great to see.

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). Doing so will help them establish if the stock's future looks promising or ominous. If you're wondering about Gap's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Gap Making Efficient Use Of Its Profits?

Gap's three-year median payout ratio is a pretty moderate 28%, meaning the company retains 72% of its income. This suggests that its dividend is well covered, and given the high growth we discussed above, it looks like Gap is reinvesting its earnings efficiently.

Besides, Gap has been paying dividends for at least ten years or more. This shows that the company is committed to sharing profits with its shareholders. Based on the latest analysts' estimates, we found that the company's future payout ratio over the next three years is expected to hold steady at 25%. Still, forecasts suggest that Gap's future ROE will drop to 19% even though the the company's payout ratio is not expected to change by much.

Summary

In total, we are pretty happy with Gap's performance. Specifically, we like that the company is reinvesting a huge chunk of its profits at a high rate of return. This of course has caused the company to see substantial growth in its earnings. With that said, the latest industry analyst forecasts reveal that the company's earnings growth is expected to slow down. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.

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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.