Royalty Pharma plc's (NASDAQ:RPRX) Has Performed Well But Fundamentals Look Varied: Is There A Clear Direction For The Stock?

Most readers would already know that Royalty Pharma's (NASDAQ:RPRX) stock increased by 7.5% over the past three months. Given that the stock prices usually follow long-term business performance, we wonder if the company's mixed financials could have any adverse effect on its current price price movement Particularly, we will be paying attention to Royalty Pharma's ROE today.

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.

Check out our latest analysis for Royalty Pharma

How Do You Calculate Return On Equity?

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 Royalty Pharma is:

11% = US$1.0b ÷ US$9.8b (Based on the trailing twelve months to June 2024).

The 'return' is the yearly profit. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.11 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. 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.

A Side By Side comparison of Royalty Pharma's Earnings Growth And 11% ROE

To start with, Royalty Pharma's ROE looks acceptable. Yet, the fact that the company's ROE is lower than the industry average of 22% does temper our expectations. Further research shows that Royalty Pharma's net income has shrunk at a rate of 37% over the last five years. Not to forget, the company does have a high ROE to begin with, just that it is lower than the industry average. So there might be other reasons for the earnings to shrink. Such as, the company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.

Furthermore, even when compared to the industry, which has been shrinking its earnings at a rate of 0.3% over the last few years, we found that Royalty Pharma's performance is pretty disappointing, as it suggests that the company has been shrunk its earnings at a rate faster than the industry.

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). Doing so will help them establish if the stock's future looks promising or ominous. Is Royalty Pharma fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Royalty Pharma Efficiently Re-investing Its Profits?

Royalty Pharma's declining earnings is not surprising given how the company is spending most of its profits in paying dividends, judging by its three-year median payout ratio of 55% (or a retention ratio of 45%). The business is only left with a small pool of capital to reinvest - A vicious cycle that doesn't benefit the company in the long-run. To know the 3 risks we have identified for Royalty Pharma visit our risks dashboard for free.

In addition, Royalty Pharma has been paying dividends over a period of four years suggesting that keeping up dividend payments is preferred by the management even though earnings have been in decline. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 19% over the next three years. As a result, the expected drop in Royalty Pharma's payout ratio explains the anticipated rise in the company's future ROE to 24%, over the same period.

Summary

Overall, we have mixed feelings about Royalty Pharma. Primarily, we are disappointed to see a lack of growth in earnings even in spite of a moderate ROE. Bear in mind, the company reinvests a small portion of its profits, which explains the lack of growth. 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. 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.