Does Virtus Health Limited's (ASX:VRT) Weak Fundamentals Mean That The Market Could Correct Its Share Price?

Most readers would already be aware that Virtus Health's (ASX:VRT) stock increased significantly by 32% over the past three months. We, however wanted to have a closer look at its key financial indicators as the markets usually pay for long-term fundamentals, and in this case, they don't look very promising. In this article, we decided to focus on Virtus Health's ROE.

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

See our latest analysis for Virtus Health

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 Virtus Health is:

10% = AU$30m ÷ AU$289m (Based on the trailing twelve months to December 2019).

The 'return' is the yearly profit. That means that for every A$1 worth of shareholders' equity, the company generated A$0.10 in profit.

What Is The Relationship Between ROE And Earnings Growth?

Thus far, we have learnt that ROE measures how efficiently a company is generating its profits. 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 everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.

Virtus Health's Earnings Growth And 10% ROE

On the face of it, Virtus Health's ROE is not much to talk about. However, given that the company's ROE is similar to the average industry ROE of 11%, we may spare it some thought. However, Virtus Health has seen a flattish net income growth over the past five years, which is not saying much. Bear in mind, the company's ROE is not very high. So that could also be one of the reasons behind the company's flat growth in earnings.

As a next step, we compared Virtus Health's net income growth with the industry and discovered that the industry saw an average growth of 4.6% in the same period.

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. This then helps them determine if the stock is placed for a bright or bleak future. Is Virtus Health fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Virtus Health Using Its Retained Earnings Effectively?

With a high three-year median payout ratio of 68% (implying that the company keeps only 32% of its income) of its business to reinvest into its business), most of Virtus Health's profits are being paid to shareholders, which explains the absence of growth in earnings.

Additionally, Virtus Health has paid dividends over a period of six years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 45% over the next three years. However, Virtus Health's future ROE is expected to decline to 7.6% despite the expected decline in its payout ratio. We infer that there could be other factors that could be steering the foreseen decline in the company's ROE.

Summary

Overall, we would be extremely cautious before making any decision on Virtus Health. The company has seen a lack of earnings growth as a result of retaining very little profits and whatever little it does retain, is being reinvested at a very low rate of return. Having said that, looking current analyst estimates, we found that the company's earnings growth rate is expected to see a marginal 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.

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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. Thank you for reading.