Does Gooch & Housego PLC's (LON:GHH) Weak Fundamentals Mean That The Market Could Correct Its Share Price?

Gooch & Housego's (LON:GHH) stock is up by a considerable 11% over the past week. However, in this article, we decided to focus on its weak fundamentals, as long-term financial performance of a business is what ultimately dictates market outcomes. In this article, we decided to focus on Gooch & Housego's 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 Gooch & Housego

How Do You Calculate Return On Equity?

Return on equity 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 Gooch & Housego is:

1.2% = UK£1.3m ÷ UK£107m (Based on the trailing twelve months to March 2024).

The 'return' is the income the business earned over the last year. That means that for every £1 worth of shareholders' equity, the company generated £0.01 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. 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. 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 Gooch & Housego's Earnings Growth And 1.2% ROE

As you can see, Gooch & Housego's ROE looks pretty weak. Even compared to the average industry ROE of 10%, the company's ROE is quite dismal. For this reason, Gooch & Housego's five year net income decline of 21% is not surprising given its lower ROE. We reckon that there could also be other factors at play here. Such as - low earnings retention or poor allocation of capital.

That being said, we compared Gooch & Housego's performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 11% in the same 5-year period.

Earnings growth is an important metric to consider when valuing a stock. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. This then helps them determine if the stock is placed for a bright or bleak future. Is Gooch & Housego fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Gooch & Housego Making Efficient Use Of Its Profits?

With a high three-year median payout ratio of 77% (implying that 23% of the profits are retained), most of Gooch & Housego's profits are being paid to shareholders, which explains the company's shrinking earnings. With only very little left to reinvest into the business, growth in earnings is far from likely. You can see the 2 risks we have identified for Gooch & Housego by visiting our risks dashboard for free on our platform here.

In addition, Gooch & Housego 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. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 33% over the next three years. The fact that the company's ROE is expected to rise to 7.8% over the same period is explained by the drop in the payout ratio.

Conclusion

On the whole, Gooch & Housego's 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 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.