Should Weakness in H. Lundbeck A/S' (CPH:HLUN A) Stock Be Seen As A Sign That Market Will Correct The Share Price Given Decent Financials?

H. Lundbeck (CPH:HLUN A) has had a rough three months with its share price down 8.2%. 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. Specifically, we decided to study H. Lundbeck'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. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

See our latest analysis for H. Lundbeck

How To Calculate Return On Equity?

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 H. Lundbeck is:

11% = kr.2.5b ÷ kr.22b (Based on the trailing twelve months to September 2023).

The 'return' refers to a company's earnings over the last year. That means that for every DKK1 worth of shareholders' equity, the company generated DKK0.11 in profit.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. 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.

H. Lundbeck's Earnings Growth And 11% ROE

To begin with, H. Lundbeck seems to have a respectable ROE. Even when compared to the industry average of 11% the company's ROE looks quite decent. As you might expect, the 14% net income decline reported by H. Lundbeck is a bit of a surprise. Based on this, we feel that there might be other reasons which haven't been discussed so far in this article that could be hampering the company's growth. These include low earnings retention or poor allocation of capital.

So, as a next step, we compared H. Lundbeck's performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 13% over the last few years.

Earnings growth is an important metric to consider when valuing a stock. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. 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 H. Lundbeck is trading on a high P/E or a low P/E, relative to its industry.

Is H. Lundbeck Efficiently Re-investing Its Profits?

In spite of a normal three-year median payout ratio of 27% (that is, a retention ratio of 73%), the fact that H. Lundbeck's earnings have shrunk is quite puzzling. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.

Additionally, H. Lundbeck started paying a dividend only recently. So it looks like the management may have perceived that shareholders favor dividends even though earnings have been in decline. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 20% over the next three years. As a result, the expected drop in H. Lundbeck's payout ratio explains the anticipated rise in the company's future ROE to 14%, over the same period.

Conclusion

In total, it does look like H. Lundbeck has some positive aspects to its business. However, given the high ROE and high profit retention, we would expect the company to be delivering strong earnings growth, but that isn't the case here. This suggests that there might be some external threat to the business, that's hampering its growth. That being so, the latest industry analyst forecasts show that the analysts are expecting to see a huge improvement in the company's earnings growth rate. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.