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Most readers would already be aware that Volex's (LON:VLX) stock increased significantly by 16% over the past three months. Given the company's impressive performance, we decided to study its financial indicators more closely as a company's financial health over the long-term usually dictates market outcomes. In this article, we decided to focus on Volex's ROE.
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 other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
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 Volex is:
15% = US$22m ÷ US$151m (Based on the trailing twelve months to October 2020).
The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each £1 of shareholders' capital it has, the company made £0.15 in profit.
What Is The Relationship Between ROE And Earnings Growth?
We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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.
Volex's Earnings Growth And 15% ROE
At first glance, Volex seems to have a decent ROE. Further, the company's ROE compares quite favorably to the industry average of 11%. Probably as a result of this, Volex was able to see an impressive net income growth of 68% over the last five years. However, there could also be other causes behind this growth. Such as - high earnings retention or an efficient management in place.
We then compared Volex's net income growth with the industry and we're pleased to see that the company's growth figure is higher when compared with the industry which has a growth rate of 4.7% 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 Volex is trading on a high P/E or a low P/E, relative to its industry.
Is Volex Efficiently Re-investing Its Profits?
Volex's three-year median payout ratio is a pretty moderate 26%, meaning the company retains 74% of its income. By the looks of it, the dividend is well covered and Volex is reinvesting its profits efficiently as evidenced by its exceptional growth which we discussed above.
Additionally, Volex has paid dividends over a period of at least ten years which means that the company is pretty serious about sharing its profits with shareholders. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 19% over the next three years.
In total, we are pretty happy with Volex's performance. In particular, it's great to see that the company is investing heavily into its business and along with a high rate of return, that has resulted in a sizeable growth in its earnings. If the company continues to grow its earnings the way it has, that could have a positive impact on its share price given how earnings per share influence long-term share prices. Let's not forget, business risk is also one of the factors that affects the price of the stock. So this is also an important area that investors need to pay attention to before making a decision on any business. You can see the 1 risk we have identified for Volex by visiting our risks dashboard for free on our platform here.
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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