Nichols' (LON:NICL) stock is up by a considerable 41% over the past three months. However, in this article, we decided to focus on its weak fundamentals, as long-term financial performance of a business is what ultimatley dictates market outcomes. In this article, we decided to focus on Nichols' ROE.
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.
How Is ROE Calculated?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Nichols is:
4.0% = UK£4.9m ÷ UK£120m (Based on the trailing twelve months to December 2020).
The 'return' is the profit over the last twelve months. So, this means that for every £1 of its shareholder's investments, the company generates a profit of £0.04.
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.
Nichols' Earnings Growth And 4.0% ROE
When you first look at it, Nichols' ROE doesn't look that attractive. We then compared the company's ROE to the broader industry and were disappointed to see that the ROE is lower than the industry average of 14%. Therefore, it might not be wrong to say that the five year net income decline of 7.4% seen by Nichols was probably the result of it having a lower ROE. We believe that there also might be other aspects that are negatively influencing the company's earnings prospects. For example, it is possible that the business has allocated capital poorly or that the company has a very high payout ratio.
As a next step, we compared Nichols' performance with the industry and found thatNichols' performance is depressing even when compared with the industry, which has shrunk its earnings at a rate of 0.5% in the same period, which is a slower than the company.
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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is Nichols fairly valued compared to other companies? These 3 valuation measures might help you decide.
Is Nichols Using Its Retained Earnings Effectively?
Nichols' declining earnings is not surprising given how the company is spending most of its profits in paying dividends, judging by its three-year median payout ratio of 55% (or a retention ratio of 45%). 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. To know the 4 risks we have identified for Nichols visit our risks dashboard for free.
Moreover, Nichols has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over earnings growth. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 52%. Still, forecasts suggest that Nichols' future ROE will rise to 17% even though the the company's payout ratio is not expected to change by much.
On the whole, Nichols' performance is quite a big let-down. As a result of its low ROE and lack of much reinvestment into the business, the company has seen a disappointing earnings growth rate. 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. 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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