Should Weakness in Arla Plast AB's (STO:ARPL) Stock Be Seen As A Sign That Market Will Correct The Share Price Given Decent Financials?

Arla Plast (STO:ARPL) has had a rough week with its share price down 14%. However, stock prices are usually driven by a company’s financials over the long term, which in this case look pretty respectable. Specifically, we decided to study Arla Plast's ROE in this article.

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 short, ROE shows the profit each dollar generates with respect to its shareholder investments.

View our latest analysis for Arla Plast

How Is ROE Calculated?

The formula for ROE is:

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

So, based on the above formula, the ROE for Arla Plast is:

13% = kr81m ÷ kr601m (Based on the trailing twelve months to March 2024).

The 'return' is the yearly profit. One way to conceptualize this is that for each SEK1 of shareholders' capital it has, the company made SEK0.13 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. 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. 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.

Arla Plast's Earnings Growth And 13% ROE

To start with, Arla Plast's ROE looks acceptable. On comparing with the average industry ROE of 9.0% the company's ROE looks pretty remarkable. As you might expect, the 5.3% net income decline reported by Arla Plast is a bit of a surprise. We reckon that there could be some other factors at play here that are preventing the company's growth. These include low earnings retention or poor allocation of capital.

That being said, we compared Arla Plast'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 8.8% in the same 5-year period.

Earnings growth is a huge factor in stock valuation. 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 Arla Plast is trading on a high P/E or a low P/E, relative to its industry.

Is Arla Plast Efficiently Re-investing Its Profits?

In spite of a normal three-year median payout ratio of 48% (that is, a retention ratio of 52%), the fact that Arla Plast's earnings have shrunk is quite puzzling. So there could be some other explanations in that regard. For instance, the company's business may be deteriorating.

Only recently, Arla Plast stated paying a dividend. This likely means that the management might have concluded that its shareholders have a strong preference for dividends.

Summary

In total, it does look like Arla Plast has some positive aspects to its business. However, given the high ROE and high profit retention, we would expect the company to be delivering strong earnings growth, but that isn't the case here. This suggests that there might be some external threat to the business, that's hampering its growth. Additionally, the latest industry analyst forecasts show that the company is expected to continue to see a similar decline in its earnings in the future as well. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page for the company.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com