Medtronic's (NYSE:MDT) stock is up by 2.9% over the past month. However, in this article, we decided to focus on its weak financials, as long-term fundamentals ultimately dictate market outcomes. Particularly, we will be paying attention to Medtronic's ROE today.
ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
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 Medtronic is:
7.0% = US$3.6b ÷ US$52b (Based on the trailing twelve months to April 2021).
The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.07 in profit.
What Is The Relationship Between ROE And 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.
A Side By Side comparison of Medtronic's Earnings Growth And 7.0% ROE
On the face of it, Medtronic's ROE is not much to talk about. We then compared the company's ROE to the broader industry and were disappointed to see that the ROE is lower than the industry average of 10%. Hence, the flat earnings seen by Medtronic over the past five years could probably be the result of it having a lower ROE.
As a next step, we compared Medtronic's net income growth with the industry and were disappointed to see that the company's growth is lower than the industry average growth of 14% 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. If you're wondering about Medtronic's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.
Is Medtronic Making Efficient Use Of Its Profits?
With a high three-year median payout ratio of 64% (implying that the company keeps only 36% of its income) of its business to reinvest into its business), most of Medtronic's profits are being paid to shareholders, which explains the absence of growth in earnings.
Additionally, Medtronic 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 38% over the next three years. The fact that the company's ROE is expected to rise to 17% over the same period is explained by the drop in the payout ratio.
In total, we would have a hard think before deciding on any investment action concerning Medtronic. As a result of its low ROE and lack of much reinvestment into the business, the company has seen a disappointing earnings growth rate. Having said that, looking at the current analyst estimates, we found that the company's earnings are expected to gain momentum. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts 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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