Lesico Ltd. (TLV:LSCO) Stock Is Going Strong But Fundamentals Look Uncertain: What Lies Ahead ?

Lesico (TLV:LSCO) has had a great run on the share market with its stock up by a significant 24% over the last three months. However, we decided to pay attention to the company's fundamentals which don't appear to give a clear sign about the company's financial health. Specifically, we decided to study Lesico'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 short, ROE shows the profit each dollar generates with respect to its shareholder investments.

See our latest analysis for Lesico

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 Lesico is:

5.8% = ₪8.7m ÷ ₪151m (Based on the trailing twelve months to December 2019).

The 'return' is the profit over the last twelve months. Another way to think of that is that for every ₪1 worth of equity, the company was able to earn ₪0.06 in profit.

What Has ROE Got To Do With Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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 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.

Lesico's Earnings Growth And 5.8% ROE

At first glance, Lesico's ROE doesn't look very promising. A quick further study shows that the company's ROE doesn't compare favorably to the industry average of 12% either. Therefore, it might not be wrong to say that the five year net income decline of 3.5% seen by Lesico was probably the result of it having a lower ROE. We reckon that there could also be other factors at play here. For example, it is possible that the business has allocated capital poorly or that the company has a very high payout ratio.

However, when we compared Lesico's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 12% in the same period. This is quite worrisome.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. This then helps them determine if the stock is placed for a bright or bleak future. If you're wondering about Lesico's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Lesico Using Its Retained Earnings Effectively?

Looking at its three-year median payout ratio of 50% (or a retention ratio of 50%) which is pretty normal, Lesico's declining earnings is rather baffling as one would expect to see a fair bit of growth when a company is retaining a good portion of its profits. It looks like there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.

Additionally, Lesico started paying a dividend only recently. So it looks like the management may have perceived that shareholders favor dividends even though earnings have been in decline.

Conclusion

In total, we're a bit ambivalent about Lesico's performance. 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. Wrapping up, we would proceed with caution with this company and one way of doing that would be to look at the risk profile of the business. You can see the 5 risks we have identified for Lesico by visiting our risks dashboard for free on our platform here.

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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.