Are Nestlé S.A.'s (VTX:NESN) Fundamentals Good Enough to Warrant Buying Given The Stock's Recent Weakness?

It is hard to get excited after looking at Nestlé's (VTX:NESN) recent performance, when its stock has declined 7.0% over the past three months. But if you pay close attention, you might find that its key financial indicators look quite decent, which could mean that the stock could potentially rise in the long-term given how markets usually reward more resilient long-term fundamentals. Particularly, we will be paying attention to Nestlé's ROE today.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. Put another way, it reveals the company's success at turning shareholder investments into profits.

See our latest analysis for Nestlé

How Is ROE Calculated?

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 Nestlé is:

31% = CHF14b ÷ CHF45b (Based on the trailing twelve months to June 2020).

The 'return' is the profit over the last twelve months. One way to conceptualize this is that for each CHF1 of shareholders' capital it has, the company made CHF0.31 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 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.

Nestlé's Earnings Growth And 31% ROE

Firstly, we acknowledge that Nestlé has a significantly high ROE. Secondly, even when compared to the industry average of 13% the company's ROE is quite impressive. However, for some reason, the higher returns aren't reflected in Nestlé's meagre five year net income growth average of 3.2%. This is generally not the case as when a company has a high rate of return it should usually also have a high earnings growth rate. We reckon that a low growth, when returns are quite high could be the result of certain circumstances like low earnings retention or or poor allocation of capital.

As a next step, we compared Nestlé's net income growth with the industry and found that the company has a similar growth figure when compared with the industry average growth rate of 3.2% 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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Has the market priced in the future outlook for NESN? You can find out in our latest intrinsic value infographic research report.

Is Nestlé Making Efficient Use Of Its Profits?

Nestlé has a three-year median payout ratio of 76% (implying that it keeps only 24% of its profits), meaning that it pays out most of its profits to shareholders as dividends, and as a result, the company has seen low earnings growth.

Moreover, Nestlé has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over earnings growth. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 61% over the next three years. Despite the lower expected payout ratio, the company's ROE is not expected to change by much.

Conclusion

On the whole, we do feel that Nestlé has some positive attributes. Its earnings growth is decent, and the high ROE does contribute to that growth. However, investors could have benefitted even more from the high ROE, had the company been reinvesting more of its earnings. 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 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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