It is hard to get excited after looking at Automatic Data Processing's (NASDAQ:ADP) recent performance, when its stock has declined 3.5% 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. Specifically, we decided to study Automatic Data Processing's ROE in this article.

ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. Put another way, it reveals the company's success at turning shareholder investments into profits.

Trump has pledged to "unleash" American oil and gas and these 15 US stocks have developments that are poised to benefit.

How Is ROE Calculated?

The formula for ROE is:

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

So, based on the above formula, the ROE for Automatic Data Processing is:

77% = US$3.9b ÷ US$5.1b (Based on the trailing twelve months to December 2024).

The 'return' is the profit over the last twelve months. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.77.

View our latest analysis for Automatic Data Processing

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don’t share these attributes.

Automatic Data Processing's Earnings Growth And 77% ROE

To begin with, Automatic Data Processing has a pretty high ROE which is interesting. Secondly, even when compared to the industry average of 21% the company's ROE is quite impressive. This likely paved the way for the modest 11% net income growth seen by Automatic Data Processing over the past five years.

As a next step, we compared Automatic Data Processing's net income growth with the industry and found that the company has a similar growth figure when compared with the industry average growth rate of 10% in the same period.

Earnings growth is an important metric to consider when valuing a stock. 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. 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 Automatic Data Processing is trading on a high P/E or a low P/E, relative to its industry.

Is Automatic Data Processing Making Efficient Use Of Its Profits?

The high three-year median payout ratio of 59% (or a retention ratio of 41%) for Automatic Data Processing suggests that the company's growth wasn't really hampered despite it returning most of its income to its shareholders.

Besides, Automatic Data Processing 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 58%. Still, forecasts suggest that Automatic Data Processing's future ROE will drop to 61% even though the the company's payout ratio is not expected to change by much.

Summary

On the whole, we feel that Automatic Data Processing's performance has been quite good. In particular, its high ROE is quite noteworthy and also the probable explanation behind its considerable earnings growth. Yet, the company is retaining a small portion of its profits. Which means that the company has been able to grow its earnings in spite of it, so that's not too bad. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.