Declining Stock and Decent Financials: Is The Market Wrong About Omega Flex, Inc. (NASDAQ:OFLX)?

Omega Flex (NASDAQ:OFLX) has had a rough month with its share price down 8.5%. However, stock prices are usually driven by a company’s financials over the long term, which in this case look pretty respectable. In this article, we decided to focus on Omega Flex's ROE.

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

See our latest analysis for Omega Flex

How Do You Calculate Return On Equity?

The formula for ROE is:

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

So, based on the above formula, the ROE for Omega Flex is:

44% = US$18m ÷ US$42m (Based on the trailing twelve months to September 2020).

The 'return' refers to a company's earnings over the last year. That means that for every $1 worth of shareholders' equity, the company generated $0.44 in profit.

What Has ROE Got To Do With 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. 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.

Omega Flex's Earnings Growth And 44% ROE

Firstly, we acknowledge that Omega Flex has a significantly high ROE. Additionally, the company's ROE is higher compared to the industry average of 11% which is quite remarkable. However, for some reason, the higher returns aren't reflected in Omega Flex's meagre five year net income growth average of 4.7%. This is interesting as the high returns should mean that the company has the ability to generate high growth but for some reason, it hasn't been able to do so. A few likely reasons why this could happen is that the company could have a high payout ratio or the business has allocated capital poorly, for instance.

We then compared Omega Flex's net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 9.4% in the same period, which is a bit concerning.

Earnings growth is an important metric to consider when valuing a stock. 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. 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 Omega Flex is trading on a high P/E or a low P/E, relative to its industry.

Is Omega Flex Using Its Retained Earnings Effectively?

With a high three-year median payout ratio of 52% (or a retention ratio of 48%), most of Omega Flex's profits are being paid to shareholders. This definitely contributes to the low earnings growth seen by the company.

In addition, Omega Flex has been paying dividends over a period of seven years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth.

Summary

On the whole, we do feel that Omega Flex 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. While we won't completely dismiss the company, what we would do, is try to ascertain how risky the business is to make a more informed decision around the company. Our risks dashboard will have the 1 risk we have identified for Omega Flex.

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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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