Merck KGaA's (ETR:MRK) Fundamentals Look Pretty Strong: Could The Market Be Wrong About The Stock?

With its stock down 11% over the past three months, it is easy to disregard Merck KGaA (ETR:MRK). 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 Merck KGaA's ROE today.

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.

View our latest analysis for Merck KGaA

How To Calculate Return On Equity?

The formula for ROE is:

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

So, based on the above formula, the ROE for Merck KGaA is:

9.2% = €2.6b ÷ €29b (Based on the trailing twelve months to June 2024).

The 'return' is the income the business earned over the last year. That means that for every €1 worth of shareholders' equity, the company generated €0.09 in profit.

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. 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.

A Side By Side comparison of Merck KGaA's Earnings Growth And 9.2% ROE

To begin with, Merck KGaA seems to have a respectable ROE. Yet, the fact that the company's ROE is lower than the industry average of 15% does temper our expectations. Merck KGaA was still able to see a decent net income growth of 16% over the past five years. We reckon that there could be other factors at play here. Such as - high earnings retention or an efficient management in place. Bear in mind, the company does have a respectable level of ROE. It is just that the industry ROE is higher. So this also provides some context to the earnings growth seen by the company.

We then compared Merck KGaA's net income growth with the industry and we're pleased to see that the company's growth figure is higher when compared with the industry which has a growth rate of 13% in the same 5-year period.

Earnings growth is a huge factor in stock valuation. 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 Merck KGaA is trading on a high P/E or a low P/E, relative to its industry.

Is Merck KGaA Making Efficient Use Of Its Profits?

With a three-year median payout ratio of 29% (implying that the company retains 71% of its profits), it seems that Merck KGaA is reinvesting efficiently in a way that it sees respectable amount growth in its earnings and pays a dividend that's well covered.

Moreover, Merck KGaA is determined to keep sharing its profits with shareholders which we infer from its long history of paying a dividend for at least ten years. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 24% of its profits over the next three years. Still, forecasts suggest that Merck KGaA's future ROE will rise to 13% even though the the company's payout ratio is not expected to change by much.

Conclusion

In total, we are pretty happy with Merck KGaA's performance. Particularly, we like that the company is reinvesting heavily into its business at a moderate rate of return. Unsurprisingly, this has led to an impressive earnings growth. That being so, a study of the latest analyst forecasts show that the company is expected to see a slowdown in its future earnings growth. 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.