Johnson Matthey (LON:JMAT) has had a great run on the share market with its stock up by a significant 13% over the last three months. But the company’s key financial indicators appear to be differing across the board and that makes us question whether or not the company’s current share price momentum can be maintained. Specifically, we decided to study Johnson Matthey’s ROE in this article.
Return on equity or ROE is a key measure used to assess how efficiently a company’s management is utilizing the company’s capital. In simpler terms, it measures the profitability of a company in relation to shareholder’s equity.
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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 Johnson Matthey is:
9.0% = UK£255m ÷ UK£2.8b (Based on the trailing twelve months to March 2020).
The ‘return’ refers to a company’s earnings over the last year. Another way to think of that is that for every £1 worth of equity, the company was able to earn £0.09 in profit.
What Has ROE Got To Do With Earnings Growth?
So far, we’ve learned that ROE is a measure of a company’s profitability. Based on how much of its profits the company chooses to reinvest or “retain”, we are then able to evaluate a company’s future ability to generate profits. 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.
Johnson Matthey’s Earnings Growth And 9.0% ROE
At first glance, Johnson Matthey’s ROE doesn’t look very promising. Yet, a closer study shows that the company’s ROE is similar to the industry average of 9.9%. But then again, Johnson Matthey’s five year net income shrunk at a rate of 5.0%. Remember, the company’s ROE is a bit low to begin with. Therefore, the decline in earnings could also be the result of this.
That being said, we compared Johnson Matthey’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 5.3% 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. If you’re wondering about Johnson Matthey’s’s valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.
Is Johnson Matthey Making Efficient Use Of Its Profits?
In spite of a normal three-year median payout ratio of 43% (that is, a retention ratio of 57%), the fact that Johnson Matthey’s earnings have shrunk is quite puzzling. It looks like there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.
In addition, Johnson Matthey has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Upon studying the latest analysts’ consensus data, we found that the company’s future payout ratio is expected to drop to 34% over the next three years. As a result, the expected drop in Johnson Matthey’s payout ratio explains the anticipated rise in the company’s future ROE to 13%, over the same period.
Conclusion
On the whole, we feel that the performance shown by Johnson Matthey can be open to many interpretations. Even though it appears to be retaining most of its profits, given the low ROE, investors may not be benefitting from all that reinvestment after all. The low earnings growth suggests our theory correct. Having said that, looking at current analyst estimates, we found that the company’s earnings growth rate is expected to see a huge improvement. 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.
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