Most readers would already be aware that CML Microsystems' (LON:CML) stock increased significantly by 25% over the past three months. 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 CML Microsystems' 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 CML Microsystems is:
3.6% = UK£1.5m ÷ UK£42m (Based on the trailing twelve months to March 2020).
The 'return' refers to a company's earnings over the last year. So, this means that for every £1 of its shareholder's investments, the company generates a profit of £0.04.
What Is The Relationship Between ROE And Earnings Growth?
Thus far, we have learnt that ROE measures how efficiently a company is generating its profits. 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 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.
CML Microsystems' Earnings Growth And 3.6% ROE
At first glance, CML Microsystems' ROE doesn't look very promising. Next, when compared to the average industry ROE of 6.7%, the company's ROE leaves us feeling even less enthusiastic. For this reason, CML Microsystems' five year net income decline of 5.6% is not surprising given its lower ROE. 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.
Next, on comparing with the industry net income growth, we found that CML Microsystems' earnings seems to be shrinking at a similar rate as the industry which shrunk at a rate of a rate of 5.6% in the same period.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. 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 CML Microsystems is trading on a high P/E or a low P/E, relative to its industry.
Is CML Microsystems Making Efficient Use Of Its Profits?
Despite having a normal three-year median payout ratio of 38% (where it is retaining 62% of its profits), CML Microsystems has seen a decline in earnings as we saw above. It looks like there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.
Additionally, CML Microsystems has paid dividends over a period of nine years, which means that the company's management is rather focused on keeping up its dividend payments, regardless of the shrinking earnings.
On the whole, we feel that the performance shown by CML Microsystems can be open to many interpretations. While the company does have a high rate of profit retention, its low rate of return is probably hampering its earnings growth. Wrapping up, we would proceed with caution with this company and one way of doing that would be to look at the risk profile of the business. Our risks dashboard would have the 5 risks we have identified for CML Microsystems.
Love or hate this article? Concerned about the content? Get in touch with us directly. Alternatively, email email@example.com.
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. Thank you for reading.