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Should Weakness in Medibank Private Limited's (ASX:MPL) Stock Be Seen As A Sign That Market Will Correct The Share Price Given Decent Financials?

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  • MDBPF

With its stock down 7.5% over the past three months, it is easy to disregard Medibank Private (ASX:MPL). However, the company's fundamentals look pretty decent, and long-term financials are usually aligned with future market price movements. In this article, we decided to focus on Medibank Private's ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

View our latest analysis for Medibank Private

How To Calculate Return On Equity?

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 Medibank Private is:

19% = AU$363m ÷ AU$1.9b (Based on the trailing twelve months to December 2020).

The 'return' is the amount earned after tax over the last twelve months. Another way to think of that is that for every A$1 worth of equity, the company was able to earn A$0.19 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. 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.

Medibank Private's Earnings Growth And 19% ROE

To begin with, Medibank Private seems to have a respectable ROE. On comparing with the average industry ROE of 9.2% the company's ROE looks pretty remarkable. For this reason, Medibank Private's five year net income decline of 2.8% raises the question as to why the high ROE didn't translate into earnings growth. 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. These include low earnings retention or poor allocation of capital.

That being said, we compared Medibank Private'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 3.2% in the same period.

past-earnings-growth
past-earnings-growth

Earnings growth is a huge factor in stock valuation. 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. Is MPL fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is Medibank Private Efficiently Re-investing Its Profits?

Medibank Private's declining earnings is not surprising given how the company is spending most of its profits in paying dividends, judging by its three-year median payout ratio of 87% (or a retention ratio of 13%). With only a little being reinvested into the business, earnings growth would obviously be low or non-existent.

In addition, Medibank Private has been paying dividends over a period of six years suggesting that keeping up dividend payments is preferred by the management even though earnings have been in decline. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 85%. As a result, Medibank Private's ROE is not expected to change by much either, which we inferred from the analyst estimate of 23% for future ROE.

Conclusion

On the whole, we do feel that Medibank Private has some positive attributes. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE. Bear in mind, the company reinvests a small portion of its profits, which means that investors aren't reaping the benefits of the high rate of return. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.