Are Robust Financials Driving The Recent Rally In Diploma PLC's (LON:DPLM) Stock?

Diploma (LON:DPLM) has had a great run on the share market with its stock up by a significant 20% over the last three months. Given that the market rewards strong financials in the long-term, we wonder if that is the case in this instance. Particularly, we will be paying attention to Diploma's ROE today.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

Check out our latest analysis for Diploma

How Is ROE Calculated?

The formula for return on equity is:

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

So, based on the above formula, the ROE for Diploma is:

13% = UK£117m ÷ UK£881m (Based on the trailing twelve months to March 2024).

The 'return' is the amount earned after tax 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 £0.13 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. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don’t share these attributes.

Diploma's Earnings Growth And 13% ROE

To start with, Diploma's ROE looks acceptable. Even when compared to the industry average of 13% the company's ROE looks quite decent. This probably goes some way in explaining Diploma's moderate 19% growth over the past five years amongst other factors.

As a next step, we compared Diploma's net income growth with the industry, and pleasingly, we found that the growth seen by the company is higher than the average industry growth of 15%.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. 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 Diploma is trading on a high P/E or a low P/E, relative to its industry.

Is Diploma Efficiently Re-investing Its Profits?

The high three-year median payout ratio of 71% (or a retention ratio of 29%) for Diploma suggests that the company's growth wasn't really hampered despite it returning most of its income to its shareholders.

Besides, Diploma 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 37% over the next three years. The fact that the company's ROE is expected to rise to 18% over the same period is explained by the drop in the payout ratio.

Summary

Overall, we are quite pleased with Diploma's performance. We are particularly impressed by the considerable earnings growth posted by the company, which was likely backed by its high ROE. While the company is paying out most of its earnings as dividends, it has been able to grow its earnings in spite of it, so that's probably a good sign. The latest industry analyst forecasts show that the company is expected to maintain its current 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.

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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.

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