It is hard to get excited after looking at AO World's (LON:AO.) recent performance, when its stock has declined 31% over the past month. However, stock prices are usually driven by a company’s financial performance over the long term, which in this case looks quite promising. Particularly, we will be paying attention to AO World's ROE today.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Put another way, it reveals the company's success at turning shareholder investments into profits.

See our latest analysis for AO World

How Do You 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 AO World is:

18% = UK£17m ÷ UK£96m (Based on the trailing twelve months to March 2021).

The 'return' is the yearly profit. So, this means that for every £1 of its shareholder's investments, the company generates a profit of £0.18.

What Is The Relationship Between ROE And Earnings Growth?

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

AO World's Earnings Growth And 18% ROE

At first glance, AO World seems to have a decent ROE. Further, the company's ROE is similar to the industry average of 18%. This probably goes some way in explaining AO World's significant 35% net income growth over the past five years amongst other factors. However, there could also be other drivers behind this growth. For example, it is possible that the company's management has made some good strategic decisions, or that the company has a low payout ratio.

Next, on comparing with the industry net income growth, we found that AO World's growth is quite high when compared to the industry average growth of 23% 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. 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. Is AO World fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is AO World Using Its Retained Earnings Effectively?

AO World doesn't pay any dividend currently which essentially means that it has been reinvesting all of its profits into the business. This definitely contributes to the high earnings growth number that we discussed above.

Summary

Overall, we are quite pleased with AO World's 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 sizeable growth in its earnings. On studying current analyst estimates, we found that analysts expect the company to continue its recent growth streak. 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.

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.

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