Medtronic plc's (NYSE:MDT) Stock Going Strong But Fundamentals Look Weak: What Implications Could This Have On The Stock?

Medtronic's (NYSE:MDT) stock is up by a considerable 12% over the past month. 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. In this article, we decided to focus on Medtronic'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. Put another way, it reveals the company's success at turning shareholder investments into profits.

See our latest analysis for Medtronic

How Do You Calculate Return On Equity?

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 Medtronic is:

8.9% = US$4.3b ÷ US$49b (Based on the trailing twelve months to October 2024).

The 'return' is the amount earned after tax over the last twelve months. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.09 in profit.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. 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 Medtronic's Earnings Growth And 8.9% ROE

On the face of it, Medtronic's ROE is not much to talk about. Next, when compared to the average industry ROE of 12%, the company's ROE leaves us feeling even less enthusiastic. For this reason, Medtronic's five year net income decline of 2.6% is not surprising given its lower ROE. We reckon that there could also be other factors at play here. For instance, the company has a very high payout ratio, or is faced with competitive pressures.

However, when we compared Medtronic's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 12% in the same period. This is quite worrisome.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is MDT fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is Medtronic Making Efficient Use Of Its Profits?

Medtronic has a high three-year median payout ratio of 87% (that is, it is retaining 13% 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 a little being reinvested into the business, earnings growth would obviously be low or non-existent.

In addition, Medtronic 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 48% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 15%, over the same period.

Conclusion

Overall, we would be extremely cautious before making any decision on Medtronic. As a result of its low ROE and lack of much reinvestment into the business, the company has seen a disappointing earnings growth rate. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. 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.