Lonza Group’s (VTX:LONN) stock is up by a considerable 14% over the past three months. Given that the market rewards strong financials in the long-term, we wonder if that is the case in this instance. Particularly, we will be paying attention to Lonza Group’s ROE today.
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.
How Do You 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 Lonza Group is:
13% = CHF848m ÷ CHF6.5b (Based on the trailing twelve months to June 2020).
The ‘return’ refers to a company’s earnings over the last year. Another way to think of that is that for every CHF1 worth of equity, the company was able to earn CHF0.13 in profit.
What Is The Relationship Between ROE And 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.
Lonza Group’s Earnings Growth And 13% ROE
To start with, Lonza Group’s ROE looks acceptable. Even when compared to the industry average of 12% the company’s ROE looks quite decent. This certainly adds some context to Lonza Group’s exceptional 25% net income growth seen over the past five years. We reckon that there could also be other factors at play here. For example, it is possible that the company’s management has made some good strategic decisions, or that the company has a low payout ratio.
As a next step, we compared Lonza Group’s net income growth with the industry, and pleasingly, we found that the growth seen by the company is higher than the average industry growth of 17%.
Earnings growth is an important metric to consider when valuing a stock. 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. One good indicator of expected earnings growth is the P/E ratio which determines the price the market is willing to pay for a stock based on its earnings prospects. So, you may want to check if Lonza Group is trading on a high P/E or a low P/E, relative to its industry.
Is Lonza Group Using Its Retained Earnings Effectively?
The three-year median payout ratio for Lonza Group is 28%, which is moderately low. The company is retaining the remaining 72%. So it seems that Lonza Group is reinvesting efficiently in a way that it sees impressive growth in its earnings (discussed above) and pays a dividend that’s well covered.
Moreover, Lonza Group is determined to keep sharing its profits with shareholders which we infer from its long history of paying a dividend for at least ten years. Existing analyst estimates suggest that the company’s future payout ratio is expected to drop to 20% over the next three years. However, the company’s ROE is not expected to change by much despite the lower expected payout ratio.
Overall, we are quite pleased with Lonza Group’s performance. Specifically, we like that the company is reinvesting a huge chunk of its profits at a high rate of return. This of course has caused the company to see substantial growth in its earnings. That being so, a study of the latest analyst forecasts show that the company is expected to see a slowdown in its future earnings growth. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.
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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.
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