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With its stock down 12% over the past three months, it is easy to disregard NVE (NASDAQ:NVEC). It seems that the market might have completely ignored the positive aspects of the company's fundamentals and decided to weigh-in more on the negative aspects. Stock prices are usually driven by a company’s financial performance over the long term, and therefore we decided to pay more attention to the company's financial performance. In this article, we decided to focus on NVE's ROE.
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 Is ROE Calculated?
ROE can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for NVE is:
22% = US$15m ÷ US$65m (Based on the trailing twelve months to March 2022).
The 'return' is the income the business earned over the last year. That means that for every $1 worth of shareholders' equity, the company generated $0.22 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.
NVE's Earnings Growth And 22% ROE
Firstly, we acknowledge that NVE has a significantly high ROE. Further, even comparing with the industry average if 19%, the company's ROE is quite respectable. However, When you compare NVE's high ROE with its rather flat earnings, you are left wondering, what's causing the growth to lag? Therefore, there could be some other aspects that could potentially be preventing the company from growing. Such as, the company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.
As a next step, we compared NVE's net income growth with the industry and discovered that the industry saw an average growth of 24% in the same period.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. This then helps them determine if the stock is placed for a bright or bleak future. 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 NVE is trading on a high P/E or a low P/E, relative to its industry.
Is NVE Using Its Retained Earnings Effectively?
NVE has a three-year median payout ratio as high as 140% meaning that the company is paying a dividend which is beyond its means. This does go some way in explaining the negligible earnings growth seen by NVE. Paying a dividend higher than reported profits is not a sustainable move. This is indicative of risk. Our risks dashboard should have the 2 risks we have identified for NVE.
Additionally, NVE has paid dividends over a period of seven years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth.
On the whole, we feel that the performance shown by NVE can be open to many interpretations. While the company does have a high rate of return, its low earnings retention is probably what's hampering its earnings growth. So far, we've only made a quick discussion around the company's earnings growth. You can do your own research on NVE and see how it has performed in the past by looking at this FREE detailed graph of past earnings, revenue and cash flows.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.