Is Weakness In CSL Limited (ASX:CSL) Stock A Sign That The Market Could be Wrong Given Its Strong Financial Prospects?

It is hard to get excited after looking at CSL's (ASX:CSL) recent performance, when its stock has declined 14% over the past three months. But if you pay close attention, you might gather that its strong financials could mean that the stock could potentially see an increase in value in the long-term, given how markets usually reward companies with good financial health. Particularly, we will be paying attention to CSL'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 other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

View our latest analysis for CSL

How Is ROE Calculated?

The formula for ROE is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for CSL is:

33% = US$2.0b ÷ US$6.1b (Based on the trailing twelve months to December 2019).

The 'return' is the amount earned after tax over the last twelve months. One way to conceptualize this is that for each A$1 of shareholders' capital it has, the company made A$0.33 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 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.

A Side By Side comparison of CSL's Earnings Growth And 33% ROE

First thing first, we like that CSL has an impressive ROE. Additionally, the company's ROE is higher compared to the industry average of 9.7% which is quite remarkable. This probably laid the groundwork for CSL's moderate 9.4% net income growth seen over the past five years.

Next, on comparing with the industry net income growth, we found that CSL's reported growth was lower than the industry growth of 21% in the same period, which is not something we like to see.

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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is CSL fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is CSL Using Its Retained Earnings Effectively?

CSL has a three-year median payout ratio of 44%, which implies that it retains the remaining 56% of its profits. This suggests that its dividend is well covered, and given the decent growth seen by the company, it looks like management is reinvesting its earnings efficiently.

Besides, CSL has been paying dividends for at least ten years or more. This shows that the company is committed to sharing profits with its shareholders. Based on the latest analysts' estimates, we found that the company's future payout ratio over the next three years is expected to hold steady at 48%. Therefore, the company's future ROE is also not expected to change by much with analysts predicting an ROE of 32%.

Summary

In total, we are pretty happy with CSL's performance. Particularly, we like that the company is reinvesting heavily into its business, and at a high rate of return. As a result, the decent growth in its earnings is not surprising. Having said that, looking at the current analyst estimates, we found that the company's earnings are expected to gain momentum. 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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