Is Weakness In Volex plc (LON:VLX) Stock A Sign That The Market Could be Wrong Given Its Strong Financial Prospects?

By
Simply Wall St
Published
July 09, 2021
AIM:VLX
Source: Shutterstock

Volex (LON:VLX) has had a rough week with its share price down 6.5%. 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. Specifically, we decided to study Volex's ROE in this article.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

View our latest analysis for Volex

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 Volex is:

21% = US$39m ÷ US$184m (Based on the trailing twelve months to April 2021).

The 'return' is the amount earned after tax over the last twelve months. One way to conceptualize this is that for each £1 of shareholders' capital it has, the company made £0.21 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 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 Volex's Earnings Growth And 21% ROE

Firstly, we acknowledge that Volex has a significantly high ROE. Secondly, even when compared to the industry average of 11% the company's ROE is quite impressive. As a result, Volex's exceptional 69% net income growth seen over the past five years, doesn't come as a surprise.

Next, on comparing with the industry net income growth, we found that Volex's growth is quite high when compared to the industry average growth of 3.6% in the same period, which is great to see.

past-earnings-growth
AIM:VLX Past Earnings Growth July 9th 2021

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. This then helps them determine if the stock is placed for a bright or bleak future. Is Volex fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Volex Using Its Retained Earnings Effectively?

Volex has a really low three-year median payout ratio of 23%, meaning that it has the remaining 77% left over to reinvest into its business. So it looks like Volex is reinvesting profits heavily to grow its business, which shows in its earnings growth.

Moreover, Volex 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's future payout ratio is expected to drop to 18% over the next three years. Regardless, the ROE is not expected to change much for the company despite the lower expected payout ratio.

Summary

On the whole, we feel that Volex's performance has been quite good. Specifically, we like that the company is reinvesting a huge chunk of its profits at a high rate of return. This of course has caused the company to see substantial growth in its earnings. Having said that, on studying current analyst estimates, we were concerned to see that while the company has grown its earnings in the past, analysts expect its earnings to shrink in the future. 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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