CML Microsystems plc's (LON:CML) Financials Are Too Obscure To Link With Current Share Price Momentum: What's In Store For the Stock?

CML Microsystems (LON:CML) has had a great run on the share market with its stock up by a significant 37% over the last three months. 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. Particularly, we will be paying attention to CML Microsystems' ROE today.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

View our latest analysis for CML Microsystems

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 CML Microsystems is:

3.1% = UK£1.3m ÷ UK£41m (Based on the trailing twelve months to September 2020).

The 'return' is the yearly profit. One way to conceptualize this is that for each £1 of shareholders' capital it has, the company made £0.03 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. 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. 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.

A Side By Side comparison of CML Microsystems' Earnings Growth And 3.1% ROE

When you first look at it, CML Microsystems' 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 5.3%. Given the circumstances, the significant decline in net income by 13% seen by CML Microsystems over the last five years is not surprising. We reckon that there could also be other factors at play here. Such as - low earnings retention or poor allocation of capital.

With the industry earnings declining at a rate of 13% in the same period, we deduce that both the company and the industry are shrinking at the same rate.

Earnings growth is an important metric to consider when valuing a stock. 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. Is CML Microsystems fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is CML Microsystems Efficiently Re-investing Its Profits?

In spite of a normal three-year median payout ratio of 48% (that is, a retention ratio of 52%), the fact that CML Microsystems' earnings have shrunk is quite puzzling. 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, CML Microsystems 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.

Summary

In total, we're a bit ambivalent about CML Microsystems' performance. Even though it appears to be retaining most of its profits, given the low ROE, investors may not be benefitting from all that reinvestment after all. The low earnings growth suggests our theory correct. Wrapping up, we would proceed with caution with this company and one way of doing that would be to look at the risk profile of the business. Our risks dashboard would have the 4 risks we have identified for CML Microsystems.

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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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