West Pharmaceutical Services' (NYSE:WST) stock up by 9.5% over the past three months. Since the market usually pay for a company’s long-term financial health, we decided to study the company’s fundamentals to see if they could be influencing the market. In this article, we decided to focus on West Pharmaceutical Services' 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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.
How Is ROE Calculated?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for West Pharmaceutical Services is:
18% = US$286m ÷ US$1.6b (Based on the trailing twelve months to June 2020).
The 'return' is the profit 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 $0.18 in profit.
What Has ROE Got To Do With 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.
A Side By Side comparison of West Pharmaceutical Services' Earnings Growth And 18% ROE
At first glance, West Pharmaceutical Services seems to have a decent ROE. Further, the company's ROE compares quite favorably to the industry average of 11%. This probably laid the ground for West Pharmaceutical Services' moderate 20% net income growth seen over the past five years.
We then compared West Pharmaceutical Services' net income growth with the industry and we're pleased to see that the company's growth figure is higher when compared with the industry which has a growth rate of 15% in the same period.
Earnings growth is an important metric to consider when valuing a stock. 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. 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 Efficiently Re-investing Its Profits?
In West Pharmaceutical Services' case, its respectable earnings growth can probably be explained by its low three-year median payout ratio of 20% (or a retention ratio of 80%), which suggests that the company is investing most of its profits to grow its business.
Additionally, West Pharmaceutical Services has paid dividends over a period of at least ten years which means that the company is pretty serious about sharing its profits with shareholders. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 16% over the next three years. Despite the lower expected payout ratio, the company's ROE is not expected to change by much.
In total, we are pretty happy with West Pharmaceutical Services' performance. Particularly, we like that the company is reinvesting heavily into its business, and at a high rate of return. Unsurprisingly, this has led to an impressive earnings growth. Having said that, the company's earnings growth is expected to slow down, as forecasted in the current analyst estimates. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.
If you’re looking to trade West Pharmaceutical Services, open an account with the lowest-cost* platform trusted by professionals, Interactive Brokers. Their clients from over 200 countries and territories trade stocks, options, futures, forex, bonds and funds worldwide from a single integrated account.
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.
*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email email@example.com.