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Essentra (LON:ESNT) has had a great run in the stock market, with its stock up a whopping 16% over the past three months. As most know, it is fundamentals that usually drive market price movements over the long term. Therefore, we decided to look at the company’s key financial indicators today to see if they play a role in the recent price action. In particular, we decided to examine Essentra’s ROE in this article.
Return on Equity, or ROE, is a key metric used to assess how efficiently a company’s management is using the company’s capital. Put simply, it is used to assess a company’s profitability in relation to its equity.
Check out our latest analysis for Essentra
How do you calculate return on equity?
The ROE can be calculated using the following formula:
Return on Equity = Net Income (from continuing operations) ÷ Equity
So, based on the formula above, the ROE for Essentra is:
4.5% = £28m ÷ £629m (based on trailing 12 months to December 2021).
The “return” is the income that the company has made in the last year. One way to think of this is that the company makes a profit of £0.04 for every £1 of shareholder capital it has.
What does ROE have to do with earnings growth?
We have already established that ROE serves as an efficient profitable measure of a company’s future profits. We now need to evaluate how much profit the company is reinvesting or “keeping” for future growth, which then gives us an idea of the company’s growth potential. In general, companies with a high return on equity and earnings retention, all other things being equal, have a higher growth rate than companies that do not share these characteristics.
A head-to-head comparison of Essentra’s earnings growth and 4.5% ROE
At first glance, Essentra’s ROE doesn’t look particularly attractive. We then compared the company’s ROE to the industry as a whole and were disappointed to find that the ROE is below the industry average of 9.2%. Even so, Essentra has surprisingly posted an exceptional 50% net income growth over the past five years. We assume that other factors could play a role here. Such as – a high accumulation of profits or efficient management.
As a next step, we compared Essentra’s net income growth to that of the industry and were pleased to find that the company’s growth is faster than the average industry growth of 6.2%.
Much of the basis for increasing the value of a company is tied to its earnings growth. It’s important for an investor to know whether the market has priced in the company’s expected earnings growth (or decline). This then helps them determine if the stock is placed for a bright or bleak future. What is ESNT worth today? The intrinsic value infographic in our free research report helps visualize if ESNT is currently mispriced by the market.
Is Essentra using its profits efficiently?
The high three-year average payout ratio of 85% (which means Essentra keeps just 15% of earnings) suggests the company’s growth hasn’t really been hampered, though it did return most of the earnings to its shareholders.
Additionally, Essentra is committed to continuing to share its profits with shareholders, which we infer from its long history of paying dividends for at least a decade. Existing analyst estimates suggest that the company’s future payout ratio is likely to drop to 30% over the next three years.
summary
Overall, it looks like Essentra has some positives in its business. While earnings growth is undoubtedly quite substantial, we think the reinvestment rate is quite low, meaning earnings growth could have been significantly higher had the company retained more of its earnings. Against this backdrop, a study of the latest analyst forecasts reveals that the company is likely to experience a slowdown in its future earnings growth. Are these analyst expectations based on broader expectations for the industry or on company fundamentals? Click here to go to our analyst’s forecast page for the company.
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This Simply Wall St article is of a general nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended as financial advice. It is not a recommendation to buy or sell any stock and does not take into account your goals or financial situation. Our goal is to offer you long-term focused analysis based on fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any of the stocks mentioned.
