Is Royalty Pharma plc's (NASDAQ:RPRX) Recent Price Movement Underpinned By Its Weak Fundamentals?
Royalty Pharma (NASDAQ:RPRX) has had a rough three months with its share price down 9.0%. It is possible that the markets have ignored the company's differing financials and decided to lean-in to the negative sentiment. 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. Specifically, we decided to study Royalty Pharma's ROE in this article.
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. Put another way, it reveals the company's success at turning shareholder investments into profits.
View our latest analysis for Royalty Pharma
How To 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 Royalty Pharma is:
2.4% = US$230m ÷ US$9.5b (Based on the trailing twelve months to December 2022).
The 'return' is the income the business earned over the last year. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.02 in profit.
Why Is ROE Important For 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. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don’t share these attributes.
Royalty Pharma's Earnings Growth And 2.4% ROE
As you can see, Royalty Pharma's ROE looks pretty weak. Even when compared to the industry average of 20%, the ROE figure is pretty disappointing. Given the circumstances, the significant decline in net income by 31% seen by Royalty Pharma over the last five years is not surprising. We reckon that there could also be other factors at play here. For example, the business has allocated capital poorly, or that the company has a very high payout ratio.
That being said, we compared Royalty Pharma's performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 18% 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. Is Royalty Pharma fairly valued compared to other companies? These 3 valuation measures might help you decide.
Is Royalty Pharma Making Efficient Use Of Its Profits?
Looking at its three-year median payout ratio of 37% (or a retention ratio of 63%) which is pretty normal, Royalty Pharma'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. It looks like there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.
Moreover, Royalty Pharma has been paying dividends for three years, which is a considerable amount of time, suggesting that management must have perceived that the shareholders prefer consistent dividends even though earnings have been shrinking. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 22% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 30%, over the same period.
Summary
On the whole, we feel that the performance shown by Royalty Pharma can be open to many interpretations. While the company does have a high rate of reinvestment, the low ROE means that all that reinvestment is not reaping any benefit to its investors, and moreover, its having a negative impact on the 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. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page for the company.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.
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