Most readers would already be aware that Cummins' (NYSE:CMI) stock increased significantly by 23% over the past three months. Given that stock prices are usually aligned with a company's financial performance in the long-term, we decided to study its financial indicators more closely to see if they had a hand to play in the recent price move. Particularly, we will be paying attention to Cummins' 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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

Check out our latest analysis for Cummins

How Is ROE Calculated?

ROE 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 Cummins is:

20% = US$2.1b ÷ US$11b (Based on the trailing twelve months to June 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 $0.20 in profit.

What Has ROE Got To Do With Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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 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.

A Side By Side comparison of Cummins' Earnings Growth And 20% ROE

To start with, Cummins' ROE looks acceptable. Especially when compared to the industry average of 15% the company's ROE looks pretty impressive. Needless to say, we are quite surprised to see that Cummins' net income shrunk at a rate of 2.2% over the past five years. We reckon that there could be some other factors at play here that are preventing the company's growth. Such as, the company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.

So, as a next step, we compared Cummins' performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 11% over the last few years.

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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Has the market priced in the future outlook for CMI? You can find out in our latest intrinsic value infographic research report.