Nichols plc's (LON:NICL) Stock On An Uptrend: Could Fundamentals Be Driving The Momentum?

Nichols' (LON:NICL) stock is up by a considerable 18% over the past month. Given that stock prices are usually aligned with a company's financial performance in the long-term, we decided to study its financial indicators more closely to see if they had a hand to play in the recent price move. Specifically, we decided to study Nichols' ROE in this article.

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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

View our latest analysis for Nichols

How To Calculate Return On Equity?

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 Nichols is:

13% = UK£12m ÷ UK£92m (Based on the trailing twelve months to June 2023).

The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each £1 of shareholders' capital it has, the company made £0.13 in profit.

What Is The Relationship Between ROE And Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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. Assuming all else is equal, companies that have both a higher return on equity and higher profit retention are usually the ones that have a higher growth rate when compared to companies that don't have the same features.

A Side By Side comparison of Nichols' Earnings Growth And 13% ROE

At first glance, Nichols seems to have a decent ROE. Further, the company's ROE is similar to the industry average of 12%. However, while Nichols has a pretty respectable ROE, its five year net income decline rate was 41% . So, there might be some other aspects that could explain this. These include low earnings retention or poor allocation of capital.

Next, when we compared with the industry, which has shrunk its earnings at a rate of 0.06% in the same 5-year period, we still found Nichols' performance to be quite bleak, because the company has been shrinking its earnings faster than the industry.

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. Is NICL fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is Nichols Efficiently Re-investing Its Profits?

Nichols has a high three-year median payout ratio of 68% (that is, it is retaining 32% of its profits). This suggests that the company is paying most of its profits as dividends to its shareholders. This goes some way in explaining why its earnings have been shrinking. The business is only left with a small pool of capital to reinvest - A vicious cycle that doesn't benefit the company in the long-run. You can see the 2 risks we have identified for Nichols by visiting our risks dashboard for free on our platform here.

In addition, Nichols has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 50% over the next three years. As a result, the expected drop in Nichols' payout ratio explains the anticipated rise in the company's future ROE to 22%, over the same period.

Conclusion

Overall, we feel that Nichols certainly does have some positive factors to consider. However, while the company does have a high ROE, its earnings growth number is quite disappointing. This can be blamed on the fact that it reinvests only a small portion of its profits and pays out the rest as dividends. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.

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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.