Dechra Pharmaceuticals PLC (LON:DPH) Is Going Strong But Fundamentals Appear To Be Mixed : Is There A Clear Direction For The Stock?

Most readers would already be aware that Dechra Pharmaceuticals' (LON:DPH) stock increased significantly by 5.6% over the past month. However, we decided to pay attention to the company's fundamentals which don't appear to give a clear sign about the company's financial health. In this article, we decided to focus on Dechra Pharmaceuticals' 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.

View our latest analysis for Dechra Pharmaceuticals

How To 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 Dechra Pharmaceuticals is:

5.3% = UK£34m ÷ UK£638m (Based on the trailing twelve months to June 2020).

The 'return' is the yearly profit. So, this means that for every £1 of its shareholder's investments, the company generates a profit of £0.05.

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. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. 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.

Dechra Pharmaceuticals' Earnings Growth And 5.3% ROE

On the face of it, Dechra Pharmaceuticals' ROE is not much to talk about. A quick further study shows that the company's ROE doesn't compare favorably to the industry average of 17% either. Dechra Pharmaceuticals was still able to see a decent net income growth of 14% over the past five years. We reckon that there could be other factors at play here. For instance, the company has a low payout ratio or is being managed efficiently.

As a next step, we compared Dechra Pharmaceuticals' 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 9.9%.

Earnings growth is a huge factor in stock valuation. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. 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 Dechra Pharmaceuticals is trading on a high P/E or a low P/E, relative to its industry.

Is Dechra Pharmaceuticals Using Its Retained Earnings Effectively?

Dechra Pharmaceuticals' high three-year median payout ratio of 104% suggests that the company is paying out more to its shareholders than what it is making. However, this hasn't really hampered its ability to grow as we saw earlier. Although, the high payout ratio is certainly something we would keep an eye on if the company is not able to keep up its growth, or if business deteriorates. Our risks dashboard should have the 3 risks we have identified for Dechra Pharmaceuticals.

Additionally, Dechra Pharmaceuticals 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. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 36% over the next three years. As a result, the expected drop in Dechra Pharmaceuticals' payout ratio explains the anticipated rise in the company's future ROE to 18%, over the same period.

Summary

Overall, we have mixed feelings about Dechra Pharmaceuticals. While no doubt its earnings growth is pretty substantial, its ROE and earnings retention is quite poor. So while the company has managed to grow its earnings in spite of this, we are unconvinced if this growth could extend, especially during troubled times. With that said, the latest industry analyst forecasts reveal that the company's earnings are expected to accelerate. 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. 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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