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Should Weakness in Lechwerke AG's (FRA:LEC) Stock Be Seen As A Sign That Market Will Correct The Share Price Given Decent Financials?

Simply Wall St

With its stock down 7.9% over the past three months, it is easy to disregard Lechwerke (FRA:LEC). However, the company's fundamentals look pretty decent, and long-term financials are usually aligned with future market price movements. Particularly, we will be paying attention to Lechwerke'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. Put another way, it reveals the company's success at turning shareholder investments into profits.

See our latest analysis for Lechwerke

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 Lechwerke is:

26% = €140m ÷ €542m (Based on the trailing twelve months to December 2019).

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 €0.26 in profit.

Why Is ROE Important For Earnings Growth?

Thus far, we have learnt that ROE measures how efficiently a company is generating its profits. Depending on how much of these profits the company reinvests or "retains", and how effectively it does so, we are then able to assess a company’s earnings growth potential. 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.

Lechwerke's Earnings Growth And 26% ROE

To begin with, Lechwerke has a pretty high ROE which is interesting. Secondly, even when compared to the industry average of 8.0% the company's ROE is quite impressive. Given the circumstances, we can't help but wonder why Lechwerke saw little to no growth in the past five years. Based on this, we feel that there might be other reasons which haven't been discussed so far in this article that could be hampering the company's growth. For example, it could be that the company has a high payout ratio or the business has allocated capital poorly, for instance.

We then compared Lechwerke's net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 7.7% in the same period, which is a bit concerning.

DB:LEC Past Earnings Growth May 16th 2020

Earnings growth is a huge factor in stock valuation. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Has the market priced in the future outlook for LEC? You can find out in our latest intrinsic value infographic research report

Is Lechwerke Making Efficient Use Of Its Profits?

Lechwerke has a high three-year median payout ratio of 78% (or a retention ratio of 22%), meaning that the company is paying most of its profits as dividends to its shareholders. This does go some way in explaining why there's been no growth in its earnings.

Additionally, Lechwerke 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.

Conclusion

Overall, we feel that Lechwerke certainly does have some positive factors to consider. Yet, the low earnings growth is a bit concerning, especially given that the company has a high rate of return. Investors could have benefitted from the high ROE, had the company been reinvesting more of its earnings. As discussed earlier, the company is retaining a small portion of its profits. So far, we've only made a quick discussion around the company's earnings growth. You can do your own research on Lechwerke and see how it has performed in the past by looking at this FREE detailed graph of past earnings, revenue and cash flows.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.