Most readers would already be aware that EKF Diagnostics Holdings' (LON:EKF) stock increased significantly by 18% over the past three months. However, we wonder if the company's inconsistent financials would have any adverse impact on the current share price momentum. Specifically, we decided to study EKF Diagnostics Holdings' ROE in this article.
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 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?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for EKF Diagnostics Holdings is:
8.4% = UK£6.6m ÷ UK£79m (Based on the trailing twelve months to June 2020).
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 £0.08 in profit.
Why Is ROE Important For Earnings Growth?
Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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 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.
EKF Diagnostics Holdings' Earnings Growth And 8.4% ROE
On the face of it, EKF Diagnostics Holdings' ROE is not much to talk about. However, given that the company's ROE is similar to the average industry ROE of 7.9%, we may spare it some thought. Particularly, the exceptional 61% net income growth seen by EKF Diagnostics Holdings over the past five years is pretty remarkable. Considering the moderately low ROE, it is quite possible that there might be some other aspects that are positively influencing the company's earnings growth. For example, it is possible that the company's management has made some good strategic decisions, or that the company has a low payout ratio.
We then compared EKF Diagnostics Holdings' net income growth with the industry and we're pleased to see that the company's growth figure is higher when compared with the industry which has a growth rate of 27% in the same period.
Earnings growth is an important metric to consider when valuing a stock. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. This then helps them determine if the stock is placed for a bright or bleak future. Is EKF Diagnostics Holdings fairly valued compared to other companies? These 3 valuation measures might help you decide.
Is EKF Diagnostics Holdings Using Its Retained Earnings Effectively?
The high three-year median payout ratio of 90% (implying that it keeps only 9.5% of profits) for EKF Diagnostics Holdings suggests that the company's growth wasn't really hampered despite it returning most of the earnings to its shareholders.
Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 55% over the next three years.
In total, we're a bit ambivalent about EKF Diagnostics Holdings' performance. While the company has posted impressive earnings growth, its poor ROE and low earnings retention makes us doubtful if that growth could continue, if by any chance the business is faced with any sort of risk. That being so, according to the latest industry analyst forecasts, the company's earnings are expected to shrink in the future. 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.
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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