Luxchem Corporation Berhad's (KLSE:LUXCHEM) Stock Has Shown A Decent Performance: Have Financials A Role To Play?

Most readers would already know that Luxchem Corporation Berhad's (KLSE:LUXCHEM) stock increased by 1.3% over the past week. Given that stock prices are usually aligned with a company's financial performance in the long-term, we decided to investigate if the company's decent financials had a hand to play in the recent price move. In this article, we decided to focus on Luxchem Corporation Berhad'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. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

See our latest analysis for Luxchem Corporation Berhad

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 Luxchem Corporation Berhad is:

14% = RM47m ÷ RM337m (Based on the trailing twelve months to December 2020).

The 'return' is the income the business earned over the last year. Another way to think of that is that for every MYR1 worth of equity, the company was able to earn MYR0.14 in profit.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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. 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 Luxchem Corporation Berhad's Earnings Growth And 14% ROE

At first glance, Luxchem Corporation Berhad seems to have a decent ROE. Further, the company's ROE compares quite favorably to the industry average of 4.7%. For this reason, Luxchem Corporation Berhad's five year net income decline of 3.3% raises the question as to why the high ROE didn't translate into earnings growth. Based on this, we feel that there might be other reasons which haven't been discussed so far in this article that could be hampering the company's growth. These include low earnings retention or poor allocation of capital.

From the 3.3% decline reported by the industry in the same period, we infer that Luxchem Corporation Berhad and its industry are both shrinking at a similar rate.

Earnings growth is a huge factor in stock valuation. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). Doing so will help them establish if the stock's future looks promising or ominous. 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 Luxchem Corporation Berhad is trading on a high P/E or a low P/E, relative to its industry.

Is Luxchem Corporation Berhad Making Efficient Use Of Its Profits?

Luxchem Corporation Berhad's declining earnings is not surprising given how the company is spending most of its profits in paying dividends, judging by its three-year median payout ratio of 53% (or a retention ratio of 47%). With only a little being reinvested into the business, earnings growth would obviously be low or non-existent. You can see the 2 risks we have identified for Luxchem Corporation Berhad by visiting our risks dashboard for free on our platform here.

In addition, Luxchem Corporation Berhad 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. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 37% over the next three years. Despite the lower expected payout ratio, the company's ROE is not expected to change by much.

Conclusion

In total, it does look like Luxchem Corporation Berhad has some positive aspects to its business. Yet, the low earnings growth is a bit concerning, especially given that the company has a high rate of return. Investors could have benefitted from the high ROE, had the company been reinvesting more of its earnings. As discussed earlier, the company is retaining a small portion of its profits. 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 company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.

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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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