Emkay Taps and Cutting Tools Limited (NSE:EMKAYTOOLS) Is Going Strong But Fundamentals Appear To Be Mixed : Is There A Clear Direction For The Stock?

Emkay Taps and Cutting Tools' (NSE:EMKAYTOOLS) stock is up by a considerable 69% over the past three months. But the company's key financial indicators appear to be differing across the board and that makes us question whether or not the company's current share price momentum can be maintained. Particularly, we will be paying attention to Emkay Taps and Cutting Tools' ROE today.

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. Put another way, it reveals the company's success at turning shareholder investments into profits.

See our latest analysis for Emkay Taps and Cutting Tools

How Is ROE Calculated?

The formula for return on equity is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Emkay Taps and Cutting Tools is:

9.3% = ₹119m ÷ ₹1.3b (Based on the trailing twelve months to September 2020).

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 ₹0.09 in profit.

What Has ROE Got To Do With 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. 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.

Emkay Taps and Cutting Tools' Earnings Growth And 9.3% ROE

At first glance, Emkay Taps and Cutting Tools' ROE doesn't look very promising. However, its ROE is similar to the industry average of 8.1%, so we won't completely dismiss the company. Having said that, Emkay Taps and Cutting Tools' five year net income decline rate was 11%. Remember, the company's ROE is a bit low to begin with. Therefore, the decline in earnings could also be the result of this.

However, when we compared Emkay Taps and Cutting Tools' growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 7.5% in the same period. This is quite worrisome.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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. 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 Emkay Taps and Cutting Tools is trading on a high P/E or a low P/E, relative to its industry.

Is Emkay Taps and Cutting Tools Making Efficient Use Of Its Profits?

Emkay Taps and Cutting Tools' low three-year median payout ratio of 2.8% (implying that it retains the remaining 97% of its profits) comes as a surprise when you pair it with the shrinking earnings. This typically shouldn't be the case when a company is retaining most of its earnings. It looks like there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.

Moreover, Emkay Taps and Cutting Tools has been paying dividends for three years, which is a considerable amount of time, suggesting that management must have perceived that the shareholders prefer consistent dividends even though earnings have been shrinking.

Conclusion

On the whole, we feel that the performance shown by Emkay Taps and Cutting Tools can be open to many interpretations. While the company does have a high rate of profit retention, its low rate of return is probably hampering its earnings growth. 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. To know the 3 risks we have identified for Emkay Taps and Cutting Tools visit our risks dashboard for free.

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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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