Royalty Pharma (NASDAQ:RPRX) has had a rough three months with its share price down 14%. But if you pay close attention, you might find that its key financial indicators look quite decent, which could mean that the stock could potentially rise in the long-term given how markets usually reward more resilient long-term fundamentals. In this article, we decided to focus on Royalty Pharma'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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.
How To 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 Royalty Pharma is:
19% = US$2.0b ÷ US$10b (Based on the trailing twelve months to June 2021).
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 $0.19 in profit.
What Is The Relationship Between ROE And Earnings Growth?
Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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. 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 Royalty Pharma's Earnings Growth And 19% ROE
To start with, Royalty Pharma's ROE looks acceptable. And on comparing with the industry, we found that the the average industry ROE is similar at 19%. However, while Royalty Pharma has a pretty respectable ROE, its five year net income decline rate was 13% . So, there might be some other aspects that could explain this. For example, it could be that the company has a high payout ratio or the business has allocated capital poorly, for instance.
However, when we compared Royalty Pharma's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 11% in the same period. This is quite worrisome.
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 Royalty Pharma is trading on a high P/E or a low P/E, relative to its industry.
Is Royalty Pharma Making Efficient Use Of Its Profits?
Looking at its three-year median payout ratio of 30% (or a retention ratio of 70%) which is pretty normal, Royalty Pharma's declining earnings is rather baffling as one would expect to see a fair bit of growth when a company is retaining a good portion of its profits. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.
Additionally, Royalty Pharma started paying a dividend only recently. So it looks like the management may have perceived that shareholders favor dividends even though earnings have been in decline. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 22% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 25%, over the same period.
Overall, we feel that Royalty Pharma certainly does have some positive factors to consider. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE and and a high reinvestment rate. We believe that there might be some outside factors that could be having a negative impact on the business. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page 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.
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