Will Weakness in Cochlear Limited's (ASX:COH) Stock Prove Temporary Given Strong Fundamentals?

Cochlear (ASX:COH) has had a rough three months with its share price down 15%. However, a closer look at its sound financials might cause you to think again. Given that fundamentals usually drive long-term market outcomes, the company is worth looking at. Particularly, we will be paying attention to Cochlear'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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

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How Do You 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 Cochlear is:

20% = AU$371m ÷ AU$1.9b (Based on the trailing twelve months to December 2024).

The 'return' is the profit over the last twelve months. So, this means that for every A$1 of its shareholder's investments, the company generates a profit of A$0.20.

Check out our latest analysis for Cochlear

What Has ROE Got To Do With Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. Depending on how much of these profits the company reinvests or "retains", and how effectively it does so, we are then able to assess a company’s earnings growth potential. 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.

Cochlear's Earnings Growth And 20% ROE

To start with, Cochlear's ROE looks acceptable. On comparing with the average industry ROE of 9.9% the company's ROE looks pretty remarkable. Probably as a result of this, Cochlear was able to see an impressive net income growth of 31% over the last five years. We reckon that there could also be other factors at play here. For instance, the company has a low payout ratio or is being managed efficiently.

Next, on comparing with the industry net income growth, we found that Cochlear's growth is quite high when compared to the industry average growth of 18% in the same period, which is great to see.

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. Doing so will help them establish if the stock's future looks promising or ominous. 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 Cochlear is trading on a high P/E or a low P/E, relative to its industry.

Is Cochlear Efficiently Re-investing Its Profits?

The high three-year median payout ratio of 73% (implying that it keeps only 27% of profits) for Cochlear suggests that the company's growth wasn't really hampered despite it returning most of the earnings to its shareholders.

Besides, Cochlear has been paying dividends for at least ten years or more. This shows that the company is committed to sharing profits with its shareholders. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 69%. Regardless, the future ROE for Cochlear is predicted to rise to 26% despite there being not much change expected in its payout ratio.

Conclusion

In total, we are pretty happy with Cochlear's performance. Especially the high ROE, Which has contributed to the impressive growth seen in earnings. Despite the company reinvesting only a small portion of its profits, it still has managed to grow its earnings so that is appreciable. With that said, the latest industry analyst forecasts reveal that the company's earnings growth is expected to slow down. 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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.