Most readers would already be aware that West Pharmaceutical Services' (NYSE:WST) stock increased significantly by 26% over the past three months. Given the company's impressive performance, we decided to study its financial indicators more closely as a company's financial health over the long-term usually dictates market outcomes. Specifically, we decided to study West Pharmaceutical Services' ROE in this article.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.
How To 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 West Pharmaceutical Services is:
26% = US$519m ÷ US$2.0b (Based on the trailing twelve months to June 2021).
The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.26 in profit.
What Is The Relationship Between ROE And 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.
West Pharmaceutical Services' Earnings Growth And 26% ROE
First thing first, we like that West Pharmaceutical Services has an impressive ROE. Additionally, the company's ROE is higher compared to the industry average of 10% which is quite remarkable. As a result, West Pharmaceutical Services' exceptional 25% net income growth seen over the past five years, doesn't come as a surprise.
Next, on comparing with the industry net income growth, we found that West Pharmaceutical Services' growth is quite high when compared to the industry average growth of 14% in the same period, which is great to see.
Earnings growth is an important metric to consider when valuing a stock. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. This then helps them determine if the stock is placed for a bright or bleak future. 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 West Pharmaceutical Services is trading on a high P/E or a low P/E, relative to its industry.
Is West Pharmaceutical Services Making Efficient Use Of Its Profits?
West Pharmaceutical Services' three-year median payout ratio to shareholders is 19%, which is quite low. This implies that the company is retaining 81% of its profits. This suggests that the management is reinvesting most of the profits to grow the business as evidenced by the growth seen by the company.
Moreover, West Pharmaceutical Services is determined to keep sharing its profits with shareholders which we infer from its long history of paying a dividend for at least ten years. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 9.7% over the next three years. Still forecasts suggest that West Pharmaceutical Services' future ROE will drop to 18% even though the the company's payout ratio is expected to decrease. This suggests that there could be other factors could driving the anticipated decline in the company's ROE.
On the whole, we feel that West Pharmaceutical Services' performance has been quite good. Specifically, we like that the company is reinvesting a huge chunk of its profits at a high rate of return. This of course has caused the company to see substantial growth in its earnings. That being so, a study of the latest analyst forecasts show that the company is expected to see a slowdown in its future earnings growth. 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.
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.
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