Most readers would already be aware that Diploma's (LON:DPLM) stock increased significantly by 15% 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. Particularly, we will be paying attention to Diploma's ROE today.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
How Do You 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 Diploma is:
13% = UK£74m ÷ UK£551m (Based on the trailing twelve months to March 2022).
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 £0.13.
What Is The Relationship Between ROE And 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. 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.
Diploma's Earnings Growth And 13% ROE
To start with, Diploma's ROE looks acceptable. Further, the company's ROE is similar to the industry average of 14%. This certainly adds some context to Diploma's moderate 7.2% net income growth seen over the past five years.
Next, on comparing with the industry net income growth, we found that Diploma's reported growth was lower than the industry growth of 9.9% in the same period, which is not something we like to see.
Earnings growth is an important metric to consider when valuing a stock. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. This then helps them determine if the stock is placed for a bright or bleak future. What is DPLM worth today? The intrinsic value infographic in our free research report helps visualize whether DPLM is currently mispriced by the market.
Is Diploma Making Efficient Use Of Its Profits?
The high three-year median payout ratio of 69% (or a retention ratio of 31%) for Diploma suggests that the company's growth wasn't really hampered despite it returning most of its income to its shareholders.
Besides, Diploma has been paying dividends for at least ten years or more. This shows that the company is committed to sharing profits with its shareholders. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 49% over the next three years. The fact that the company's ROE is expected to rise to 24% over the same period is explained by the drop in the payout ratio.
On the whole, we do feel that Diploma has some positive attributes. Its earnings have grown respectably as we saw earlier, which was likely due to the company reinvesting its earnings at a pretty high rate of return. However, given the high ROE, we do think that the company is reinvesting a small portion of its profits. This could likely be preventing the company from growing to its full extent. With that said, the latest industry analyst forecasts reveal that the company's earnings are expected to accelerate. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.
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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.
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