Will Weakness in Volex plc's (LON:VLX) Stock Prove Temporary Given Strong Fundamentals?

It is hard to get excited after looking at Volex's (LON:VLX) recent performance, when its stock has declined 12% over the past week. However, stock prices are usually driven by a company’s financial performance over the long term, which in this case looks quite promising. In this article, we decided to focus on Volex's ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

Check out the opportunities and risks within the GB Electrical industry.

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:

15% = US$30m ÷ US$201m (Based on the trailing twelve months to October 2022).

The 'return' is the profit over the last twelve months. Another way to think of that is that for every £1 worth of equity, the company was able to earn £0.15 in profit.

What Has ROE Got To Do With 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.

Volex's Earnings Growth And 15% ROE

At first glance, Volex seems to have a decent ROE. Even when compared to the industry average of 14% the company's ROE looks quite decent. This certainly adds some context to Volex's exceptional 41% net income growth seen over the past five years. However, there could also be other drivers behind this growth. Such as - high earnings retention or an efficient management in place.

We then compared Volex'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 11% in the same period.

Earnings growth is a huge factor in stock valuation. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. Doing so will help them establish if the stock's future looks promising or ominous. What is VLX worth today? The intrinsic value infographic in our free research report helps visualize whether VLX is currently mispriced by the market.

Is Volex Using Its Retained Earnings Effectively?

Volex's three-year median payout ratio to shareholders is 24%, which is quite low. This implies that the company is retaining 76% of its profits. So it seems like the management is reinvesting profits heavily to grow its business and this reflects in its earnings growth number.

Besides, Volex has been paying dividends for at least ten years or more. This shows that the company is committed to sharing profits with its shareholders. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 17% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 19%, over the same period.

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, the company's earnings growth is expected to slow down, as forecasted in the current analyst estimates. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts 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.