Can Laboratorio Farmaceutico Erfo S.p.A.'s (BIT:ERFO) Weak Financials Pull The Plug On The Stock's Current Momentum On Its Share Price?

Laboratorio Farmaceutico Erfo's (BIT:ERFO) stock is up by a considerable 33% 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. Particularly, we will be paying attention to Laboratorio Farmaceutico Erfo'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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

View our latest analysis for Laboratorio Farmaceutico Erfo

How Is ROE Calculated?

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 Laboratorio Farmaceutico Erfo is:

5.4% = €406k ÷ €7.5m (Based on the trailing twelve months to June 2024).

The 'return' is the profit over the last twelve months. That means that for every €1 worth of shareholders' equity, the company generated €0.05 in profit.

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 everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.

Laboratorio Farmaceutico Erfo's Earnings Growth And 5.4% ROE

When you first look at it, Laboratorio Farmaceutico Erfo's ROE doesn't look that attractive. A quick further study shows that the company's ROE doesn't compare favorably to the industry average of 12% either. Given the circumstances, the significant decline in net income by 25% seen by Laboratorio Farmaceutico Erfo over the last five years is not surprising. We reckon that there could also be other factors at play here. For example, it is possible that the business has allocated capital poorly or that the company has a very high payout ratio.

That being said, we compared Laboratorio Farmaceutico Erfo'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 2.9% in the same 5-year period.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is Laboratorio Farmaceutico Erfo fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Laboratorio Farmaceutico Erfo Efficiently Re-investing Its Profits?

Laboratorio Farmaceutico Erfo has a high three-year median payout ratio of 99% (that is, it is retaining 0.7% of its profits). This suggests that the company is paying most of its profits as dividends to its shareholders. This goes some way in explaining why its earnings have been shrinking. With only very little left to reinvest into the business, growth in earnings is far from likely. You can see the 4 risks we have identified for Laboratorio Farmaceutico Erfo by visiting our risks dashboard for free on our platform here.

In addition, Laboratorio Farmaceutico Erfo only recently started paying a dividend so the management probably decided the shareholders prefer dividends even though earnings have been shrinking.

Conclusion

On the whole, Laboratorio Farmaceutico Erfo's performance is quite a big let-down. Particularly, its ROE is a huge disappointment, not to mention its lack of proper reinvestment into the business. As a result its earnings growth has also been quite disappointing. 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.