Is Weakness In Treatt plc (LON:TET) Stock A Sign That The Market Could be Wrong Given Its Strong Financial Prospects?

It is hard to get excited after looking at Treatt's (LON:TET) recent performance, when its stock has declined 11% over the past week. But if you pay close attention, you might gather that its strong financials could mean that the stock could potentially see an increase in value in the long-term, given how markets usually reward companies with good financial health. Specifically, we decided to study Treatt's 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. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

View our latest analysis for Treatt

How Do You Calculate Return On Equity?

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 Treatt is:

8.2% = UK£11m ÷ UK£138m (Based on the trailing twelve months to March 2024).

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 £0.08 in profit.

What Has ROE Got To Do With Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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. Assuming everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.

Treatt's Earnings Growth And 8.2% ROE

On the face of it, Treatt's ROE is not much to talk about. However, the fact that the its ROE is quite higher to the industry average of 6.8% doesn't go unnoticed by us. Still, Treatt's net income growth of 3.1% over the past five years was mediocre at best. Remember, the company's ROE is quite low to begin with, just that it is higher than the industry average. So that could be one of the factors that are causing earnings growth to stay low.

Given that the industry shrunk its earnings at a rate of 3.8% over the last few years, the net income growth of the company is quite impressive.

Earnings growth is a huge factor in stock valuation. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. This then helps them determine if the stock is placed for a bright or bleak future. If you're wondering about Treatt's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Treatt Using Its Retained Earnings Effectively?

Despite having a moderate three-year median payout ratio of 36% (implying that the company retains the remaining 64% of its income), Treatt's earnings growth was quite low. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.

In addition, Treatt 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. 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 32%. As a result, Treatt's ROE is not expected to change by much either, which we inferred from the analyst estimate of 9.4% for future ROE.

Summary

On the whole, we feel that Treatt's performance has been quite good. Specifically, we like that it has been reinvesting a high portion of its profits at a moderate rate of return, resulting in earnings expansion. Having said that, looking at the current analyst estimates, we found that the company's earnings are expected to gain momentum. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts 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.