Virtus Health Limited's (ASX:VRT) Financial Prospects Don't Look Very Positive: Could It Mean A Stock Price Drop In The Future?

Virtus Health's (ASX:VRT) stock is up by 6.8% over the past three months. However, its weak financial performance indicators makes us a bit doubtful if that trend could continue. Specifically, we decided to study Virtus Health's ROE in this article.

ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

See our latest analysis for Virtus Health

How Is ROE Calculated?

Return on equity 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 Virtus Health is:

5.3% = AU$16m ÷ AU$297m (Based on the trailing twelve months to December 2020).

The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each A$1 of shareholders' capital it has, the company made A$0.05 in profit.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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 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.

A Side By Side comparison of Virtus Health's Earnings Growth And 5.3% ROE

When you first look at it, Virtus Health's ROE doesn't look that attractive. We then compared the company's ROE to the broader industry and were disappointed to see that the ROE is lower than the industry average of 9.9%. Therefore, it might not be wrong to say that the five year net income decline of 15% seen by Virtus Health was probably the result of it having a lower ROE. We believe that there also might be other aspects that are negatively influencing the company's earnings prospects. For example, it is possible that the business has allocated capital poorly or that the company has a very high payout ratio.

That being said, we compared Virtus Health'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 4.2% in the same period.

Earnings growth is an important metric to consider when valuing a stock. 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. Has the market priced in the future outlook for VRT? You can find out in our latest intrinsic value infographic research report.

Is Virtus Health Using Its Retained Earnings Effectively?

With a high three-year median payout ratio of 68% (implying that 32% of the profits are retained), most of Virtus Health's profits are being paid to shareholders, which explains the company's shrinking earnings. With only a little being reinvested into the business, earnings growth would obviously be low or non-existent. You can see the 5 risks we have identified for Virtus Health by visiting our risks dashboard for free on our platform here.

Additionally, Virtus Health has paid dividends over a period of seven years, which means that the company's management is rather focused on keeping up its dividend payments, regardless of the shrinking earnings. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 61%. However, Virtus Health's ROE is predicted to rise to 11% despite there being no anticipated change in its payout ratio.

Conclusion

On the whole, Virtus Health's performance is quite a big let-down. As a result of its low ROE and lack of mich reinvestment into the business, the company has seen a disappointing earnings growth rate. That being so, the latest industry analyst forecasts show that analysts are forecasting a slight improvement in the company's future earnings growth. Sure enough, this could bring some relief to shareholders. 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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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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