Should Weakness in L'Oréal S.A.'s (EPA:OR) Stock Be Seen As A Sign That Market Will Correct The Share Price Given Decent Financials?

With its stock down 19% over the past three months, it is easy to disregard L'Oréal (EPA:OR). 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. In this article, we decided to focus on L'Oréal's ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

See our latest analysis for L'Oréal

How To 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 L'Oréal is:

20% = €4.6b ÷ €24b (Based on the trailing twelve months to December 2021).

The 'return' is the yearly profit. That means that for every €1 worth of shareholders' equity, the company generated €0.20 in profit.

Why Is ROE Important For Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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 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 L'Oréal's Earnings Growth And 20% ROE

At first glance, L'Oréal seems to have a decent ROE. Especially when compared to the industry average of 12% the company's ROE looks pretty impressive. Yet, L'Oréal has posted measly growth of 2.7% over the past five years. This is interesting as the high returns should mean that the company has the ability to generate high growth but for some reason, it hasn't been able to do so. We reckon that a low growth, when returns are quite high could be the result of certain circumstances like low earnings retention or poor allocation of capital.

We then compared L'Oréal's net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 8.3% in the same period, which is a bit concerning.

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). Doing so will help them establish if the stock's future looks promising or ominous. 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 L'Oréal is trading on a high P/E or a low P/E, relative to its industry.

Is L'Oréal Efficiently Re-investing Its Profits?

The high three-year median payout ratio of 58% (that is, the company retains only 42% of its income) over the past three years for L'Oréal suggests that the company's earnings growth was lower as a result of paying out a majority of its earnings.

Moreover, L'Oréal 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. 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 53%. Accordingly, forecasts suggest that L'Oréal's future ROE will be 23% which is again, similar to the current ROE.

Conclusion

Overall, we feel that L'Oréal certainly does have some positive factors to consider. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE. Bear in mind, the company reinvests a small portion of its profits, which means that investors aren't reaping the benefits of the high rate of return. With that said, the latest industry analyst forecasts reveal that the company's earnings are expected to accelerate. 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.

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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.