Alcon Inc.'s (VTX:ALC) Stock Has Shown Weakness Lately But Financial Prospects Look Decent: Is The Market Wrong?

With its stock down 10% over the past three months, it is easy to disregard Alcon (VTX:ALC). However, stock prices are usually driven by a company’s financials over the long term, which in this case look pretty respectable. Particularly, we will be paying attention to Alcon'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. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

See our latest analysis for Alcon

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 Alcon is:

2.0% = US$376m ÷ US$19b (Based on the trailing twelve months to December 2021).

The 'return' refers to a company's earnings over the last year. Another way to think of that is that for every CHF1 worth of equity, the company was able to earn CHF0.02 in profit.

Why Is ROE Important For Earnings Growth?

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

Alcon's Earnings Growth And 2.0% ROE

When you first look at it, Alcon's ROE doesn't look that attractive. Next, when compared to the average industry ROE of 8.9%, the company's ROE leaves us feeling even less enthusiastic. As a result, Alcon reported a very low income growth of 3.8% over the past five years.

As a next step, we compared Alcon'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 3.8% in the same period.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). This then helps them determine if the stock is placed for a bright or bleak future. 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 Alcon is trading on a high P/E or a low P/E, relative to its industry.

Is Alcon Making Efficient Use Of Its Profits?

Alcon's low three-year median payout ratio of 17% (or a retention ratio of 83%) should mean that the company is retaining most of its earnings to fuel its growth. However, the low earnings growth number doesn't reflect this as high growth usually follows high profit retention. So there could be some other explanation in that regard. For instance, the company's business may be deteriorating.

Only recently, Alcon started paying a dividend. This means that the management might have concluded that its shareholders prefer dividends over earnings growth. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 12% over the next three years. As a result, the expected drop in Alcon's payout ratio explains the anticipated rise in the company's future ROE to 7.7%, over the same period.

Conclusion

On the whole, we do feel that Alcon has some positive attributes. That is, a decent growth in earnings backed by a high rate of reinvestment. However, we do feel that that earnings growth could have been higher if the business were to improve on the low ROE rate. Especially given how the company is reinvesting a huge chunk of its profits. That being so, the latest analyst forecasts show that the company will continue to see an expansion in its earnings. 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. 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.