Diploma PLC's (LON:DPLM) Stock Has Been Sliding But Fundamentals Look Strong: Is The Market Wrong?

Diploma (LON:DPLM) has had a rough three months with its share price down 6.3%. 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 Diploma's ROE.

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

See our latest analysis for Diploma

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 Diploma is:

15% = UK£130m ÷ UK£895m (Based on the trailing twelve months to September 2024).

The 'return' is the amount earned after tax over the last twelve months. That means that for every £1 worth of shareholders' equity, the company generated £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. 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 15% ROE

At first glance, Diploma seems to have a decent ROE. Further, the company's ROE is similar to the industry average of 13%. Consequently, this likely laid the ground for the impressive net income growth of 20% seen over the past five years by Diploma. We believe that there might also be other aspects that are positively influencing the company's earnings growth. For instance, the company has a low payout ratio or is being managed efficiently.

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 14%.

Earnings growth is an important metric to consider when valuing a stock. 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. Is Diploma fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Diploma Making Efficient Use Of Its Profits?

Diploma's significant three-year median payout ratio of 64% (where it is retaining only 36% of its income) suggests that the company has been able to achieve a high growth in earnings despite returning most of its income to shareholders.

Additionally, Diploma has paid dividends over a period of at least ten years which means that the company is pretty serious about sharing its profits with shareholders. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 37% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 21%, over the same period.

Summary

On the whole, we feel that Diploma's performance has been quite good. In particular, its high ROE is quite noteworthy and also the probable explanation behind its considerable earnings growth. Yet, the company is retaining a small portion of its profits. Which means that the company has been able to grow its earnings in spite of it, so that's not too bad. Having said that, the company's earnings growth is expected to slow down, as forecasted in the current analyst estimates. 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.