Most readers would already be aware that Micro-Mechanics (Holdings)'s (SGX:5DD) stock increased significantly by 22% over the past three months. Given that stock prices are usually aligned with a company's financial performance in the long-term, we decided to study its financial indicators more closely to see if they had a hand to play in the recent price move. In this article, we decided to focus on Micro-Mechanics (Holdings)'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 other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
How Do You Calculate Return On Equity?
Return on equity 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 Micro-Mechanics (Holdings) is:
26% = S$16m ÷ S$63m (Based on the trailing twelve months to September 2020).
The 'return' is the profit over the last twelve months. Another way to think of that is that for every SGD1 worth of equity, the company was able to earn SGD0.26 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. 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.
A Side By Side comparison of Micro-Mechanics (Holdings)'s Earnings Growth And 26% ROE
Firstly, we acknowledge that Micro-Mechanics (Holdings) has a significantly high ROE. Second, a comparison with the average ROE reported by the industry of 14% also doesn't go unnoticed by us. However, for some reason, the higher returns aren't reflected in Micro-Mechanics (Holdings)'s meagre five year net income growth average of 2.7%. This is generally not the case as when a company has a high rate of return it should usually also have a high earnings growth rate. We reckon that a low growth, when returns are quite high could be the result of certain circumstances like low earnings retention or or poor allocation of capital.
As a next step, we compared Micro-Mechanics (Holdings)'s net income growth with the industry and were disappointed to see that the company's growth is lower than the industry average growth of 4.7% in the same period.
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. Doing so will help them establish if the stock's future looks promising or ominous. If you're wondering about Micro-Mechanics (Holdings)'s's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.
Is Micro-Mechanics (Holdings) Efficiently Re-investing Its Profits?
With a high three-year median payout ratio of 87% (or a retention ratio of 13%), most of Micro-Mechanics (Holdings)'s profits are being paid to shareholders. This definitely contributes to the low earnings growth seen by the company.
In addition, Micro-Mechanics (Holdings) 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.
On the whole, we do feel that Micro-Mechanics (Holdings) has some positive attributes. 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. That being so, the latest analyst forecasts show that the company will continue to see an expansion in its earnings. 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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