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It is hard to get excited after looking at Merck's (NYSE:MRK) recent performance, when its stock has declined 10% 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. In this article, we decided to focus on Merck's ROE.
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
How To Calculate Return On Equity?
Return on equity 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 Merck is:
24% = US$7.1b ÷ US$29b (Based on the trailing twelve months to December 2020).
The 'return' is the profit over the last twelve months. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.24 in profit.
What Is The Relationship Between ROE And 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 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 Merck's Earnings Growth And 24% ROE
To begin with, Merck has a pretty high ROE which is interesting. Second, a comparison with the average ROE reported by the industry of 17% also doesn't go unnoticed by us. As a result, Merck's exceptional 23% net income growth seen over the past five years, doesn't come as a surprise.
Next, on comparing Merck's net income growth with the industry, we found that the company's reported growth is similar to the industry average growth rate of 23% in the same period.
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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. What is MRK worth today? The intrinsic value infographic in our free research report helps visualize whether MRK is currently mispriced by the market.
Is Merck Efficiently Re-investing Its Profits?
Merck has a significant three-year median payout ratio of 62%, meaning the company only retains 38% of its income. This implies that the company has been able to achieve high earnings growth despite returning most of its profits to shareholders.
Moreover, Merck is determined to keep sharing its profits with shareholders which we infer from its long history of paying a dividend for at least ten years. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 37% over the next three years. As a result, the expected drop in Merck's payout ratio explains the anticipated rise in the company's future ROE to 46%, over the same period.
In total, we are pretty happy with Merck's performance. Especially the high ROE, Which has contributed to the impressive growth seen in earnings. Despite the company reinvesting only a small portion of its profits, it still has managed to grow its earnings so that is appreciable. 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.
This article by Simply Wall St is general in nature. 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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