Devro's (LON:DVO) stock up by 2.5% over the past three months. We wonder if and what role the company's financials play in that price change as a company's long-term fundamentals usually dictate market outcomes. In this article, we decided to focus on Devro'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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.
How Is ROE Calculated?
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 Devro is:
25% = UK£31m ÷ UK£125m (Based on the trailing twelve months to December 2021).
The 'return' is the profit over the last twelve months. Another way to think of that is that for every £1 worth of equity, the company was able to earn £0.25 in profit.
What Has ROE Got To Do With 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. 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.
Devro's Earnings Growth And 25% ROE
Firstly, we acknowledge that Devro has a significantly high ROE. Second, a comparison with the average ROE reported by the industry of 12% also doesn't go unnoticed by us. However, for some reason, the higher returns aren't reflected in Devro's meagre five year net income growth average of 2.3%. That's a bit unexpected from a company which has such a high rate of return. We reckon that a low growth, when returns are quite high could be the result of certain circumstances like low earnings retention or or poor allocation of capital.
Next, on comparing Devro's net income growth with the industry, we found that the company's reported growth is similar to the industry average growth rate of 2.5% in the same period.
Earnings growth is a huge factor in stock valuation. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. 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 Devro is trading on a high P/E or a low P/E, relative to its industry.
Is Devro Using Its Retained Earnings Effectively?
Devro has a three-year median payout ratio of 52% (implying that it keeps only 48% of its profits), meaning that it pays out most of its profits to shareholders as dividends, and as a result, the company has seen low earnings growth.
Moreover, Devro has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over earnings growth. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 52% of its profits over the next three years. Still, forecasts suggest that Devro's future ROE will drop to 19% even though the the company's payout ratio is not expected to change by much.
In total, it does look like Devro has some positive aspects to its business. The company has grown its earnings moderately as previously discussed. Still, the high ROE could have been even more beneficial to investors had the company been reinvesting more of its profits. As highlighted earlier, the current reinvestment rate appears to be quite low. We also studied the latest analyst forecasts and found that the company's earnings growth is expected be similar to its current growth rate. 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.