Johnson Matthey's (LON:JMAT) stock is up by a considerable 9.8% over the past month. But the company's key financial indicators appear to be differing across the board and that makes us question whether or not the company's current share price momentum can be maintained. Particularly, we will be paying attention to Johnson Matthey's 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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
How To Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Johnson Matthey is:
3.8% = UK£103m ÷ UK£2.7b (Based on the trailing twelve months to September 2020).
The 'return' is the yearly profit. That means that for every £1 worth of shareholders' equity, the company generated £0.04 in profit.
Why Is ROE Important For 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 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.
A Side By Side comparison of Johnson Matthey's Earnings Growth And 3.8% ROE
When you first look at it, Johnson Matthey's ROE doesn't look that attractive. A quick further study shows that the company's ROE doesn't compare favorably to the industry average of 11% either. Given the circumstances, the significant decline in net income by 8.8% seen by Johnson Matthey over the last five years is not surprising. However, there could also be other factors causing the earnings to decline. For instance, the company has a very high payout ratio, or is faced with competitive pressures.
However, when we compared Johnson Matthey's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 5.2% in the same period. This is quite worrisome.
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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Has the market priced in the future outlook for JMAT? You can find out in our latest intrinsic value infographic research report.
Is Johnson Matthey Making Efficient Use Of Its Profits?
Looking at its three-year median payout ratio of 43% (or a retention ratio of 57%) which is pretty normal, Johnson Matthey's declining earnings is rather baffling as one would expect to see a fair bit of growth when a company is retaining a good portion of its profits. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.
Additionally, Johnson Matthey has paid dividends over a period of at least ten years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 31% over the next three years. The fact that the company's ROE is expected to rise to 13% over the same period is explained by the drop in the payout ratio.
In total, we're a bit ambivalent about Johnson Matthey's performance. While the company does have a high rate of profit retention, its low rate of return is probably hampering its earnings growth. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. 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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