Are Robust Financials Driving The Recent Rally In Nelco Limited's (NSE:NELCO) Stock?

Nelco (NSE:NELCO) has had a great run on the share market with its stock up by a significant 17% over the last three months. Given the company's impressive performance, we decided to study its financial indicators more closely as a company's financial health over the long-term usually dictates market outcomes. Particularly, we will be paying attention to Nelco's ROE today.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

Check out our latest analysis for Nelco

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 Nelco is:

20% = ₹135m ÷ ₹672m (Based on the trailing twelve months to September 2020).

The 'return' is the income the business earned over the last year. So, this means that for every ₹1 of its shareholder's investments, the company generates a profit of ₹0.20.

Why Is ROE Important For Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. Depending on how much of these profits the company reinvests or "retains", and how effectively it does so, we are then able to assess a company’s earnings growth potential. 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.

Nelco's Earnings Growth And 20% ROE

To begin with, Nelco seems to have a respectable ROE. On comparing with the average industry ROE of 6.7% the company's ROE looks pretty remarkable. This probably laid the ground for Nelco's significant 32% net income growth seen over the past five years. However, there could also be other causes behind this growth. For example, it is possible that the company's management has made some good strategic decisions, or that the company has a low payout ratio.

We then compared Nelco's net income growth with the industry and we're pleased to see that the company's growth figure is higher when compared with the industry which has a growth rate of 14% in the same period.

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. 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 Nelco is trading on a high P/E or a low P/E, relative to its industry.

Is Nelco Efficiently Re-investing Its Profits?

Nelco has a really low three-year median payout ratio of 17%, meaning that it has the remaining 83% left over to reinvest into its business. So it seems like the management is reinvesting profits heavily to grow its business and this reflects in its earnings growth number.

Moreover, Nelco is determined to keep sharing its profits with shareholders which we infer from its long history of paying a dividend for at least ten years.

Summary

On the whole, we feel that Nelco's performance has been quite good. Specifically, we like that the company is reinvesting a huge chunk of its profits at a high rate of return. This of course has caused the company to see substantial growth in its earnings. If the company continues to grow its earnings the way it has, that could have a positive impact on its share price given how earnings per share influence long-term share prices. Not to forget, share price outcomes are also dependent on the potential risks a company may face. So it is important for investors to be aware of the risks involved in the business. To know the 3 risks we have identified for Nelco 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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