Are Robust Financials Driving The Recent Rally In Electrocomponents plc's (LON:ECM) Stock?

Most readers would already be aware that Electrocomponents' (LON:ECM) stock increased significantly by 23% over the past three months. Given that the market rewards strong financials in the long-term, we wonder if that is the case in this instance. In this article, we decided to focus on Electrocomponents' ROE.

ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

See our latest analysis for Electrocomponents

How Do You Calculate Return On Equity?

The formula for ROE is:

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

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

17% = UK£130m ÷ UK£754m (Based on the trailing twelve months to September 2020).

The 'return' is the income the business earned over the last year. Another way to think of that is that for every £1 worth of equity, the company was able to earn £0.17 in profit.

What Is The Relationship Between ROE And Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. Depending on how much of these profits the company reinvests or "retains", and how effectively it does so, we are then able to assess a company’s earnings growth potential. 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.

Electrocomponents' Earnings Growth And 17% ROE

To start with, Electrocomponents' ROE looks acceptable. Even when compared to the industry average of 15% the company's ROE looks quite decent. Consequently, this likely laid the ground for the impressive net income growth of 25% seen over the past five years by Electrocomponents. We reckon that there could also be other factors at play here. For instance, the company has a low payout ratio or is being managed efficiently.

We then compared Electrocomponents' 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 10% in the same period.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. 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 Electrocomponents is trading on a high P/E or a low P/E, relative to its industry.

Is Electrocomponents Using Its Retained Earnings Effectively?

Electrocomponents' three-year median payout ratio is a pretty moderate 44%, meaning the company retains 56% of its income. This suggests that its dividend is well covered, and given the high growth we discussed above, it looks like Electrocomponents is reinvesting its earnings efficiently.

Additionally, Electrocomponents 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. 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 38%. Still, forecasts suggest that Electrocomponents' future ROE will rise to 21% even though the the company's payout ratio is not expected to change by much.

Conclusion

In total, we are pretty happy with Electrocomponents' performance. In particular, it's great to see that the company is investing heavily into its business and along with a high rate of return, that has resulted in a sizeable growth in its earnings. On studying current analyst estimates, we found that analysts expect the company to continue its recent growth streak. 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. 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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