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First Derivatives plc's (LON:FDP) Stock's Been Going Strong: Could Weak Financials Mean The Market Will Coorect Its Share Price?

Simply Wall St
·4 mins read

First Derivatives' (LON:FDP) stock is up by a considerable 37% over the past three months. We, however wanted to have a closer look at its key financial indicators as the markets usually pay for long-term fundamentals, and in this case, they don't look very promising. Particularly, we will be paying attention to First Derivatives' ROE today.

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.

Check out our latest analysis for First Derivatives

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 First Derivatives is:

9.1% = UK£15m ÷ UK£163m (Based on the trailing twelve months to February 2020).

The 'return' is the yearly profit. Another way to think of that is that for every £1 worth of equity, the company was able to earn £0.09 in profit.

What Is The Relationship Between ROE And Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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.

First Derivatives' Earnings Growth And 9.1% ROE

When you first look at it, First Derivatives' ROE doesn't look that attractive. Yet, a closer study shows that the company's ROE is similar to the industry average of 8.5%. Having said that, First Derivatives' net income growth over the past five years is more or less flat. Remember, the company's ROE is not particularly great to begin with. Hence, this provides some context to the flat earnings growth seen by the company.

Next, on comparing with the industry net income growth, we found that First Derivatives' reported growth was lower than the industry growth of 15% in the same period, which is not something we like to see.

past-earnings-growth
past-earnings-growth

Earnings growth is an important metric to consider when valuing a stock. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). Doing so will help them establish if the stock's future looks promising or ominous. 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 First Derivatives is trading on a high P/E or a low P/E, relative to its industry.

Is First Derivatives Efficiently Re-investing Its Profits?

While the company did pay out a portion of its dividend in the past, it currently doesn't pay a dividend. We infer that the company has been reinvesting all of its profits to grow its business.

Our latest analyst data shows that the future payout ratio of the company is expected to drop to 38% over the next three years. The fact that the company's ROE is expected to rise to 11% over the same period is explained by the drop in the payout ratio.

Conclusion

Overall, we would be extremely cautious before making any decision on First Derivatives. Because the company is not reinvesting much into the business, and given the low ROE, it's not surprising to see the lack or absence of growth in its earnings. With that said, the latest industry analyst forecasts reveal that the company's earnings are expected to accelerate. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com.