Royalty Pharma plc's (NASDAQ:RPRX) Stock Is Rallying But Financials Look Ambiguous: Will The Momentum Continue?

Most readers would already be aware that Royalty Pharma's (NASDAQ:RPRX) stock increased significantly by 37% over the past three months. But the company's key financial indicators appear to be differing across the board and that makes us question whether or not the company's current share price momentum can be maintained. 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. Put another way, it reveals the company's success at turning shareholder investments into profits.

Check out our latest analysis for Royalty Pharma

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:

13% = US$1.3b ÷ US$10b (Based on the trailing twelve months to December 2024).

The 'return' is the amount earned after tax over the last twelve months. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.13.

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What Is The Relationship Between ROE And 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. 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.

Royalty Pharma's Earnings Growth And 13% 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 18% does temper our expectations. Moreover, Royalty Pharma's net income shrunk at a rate of 25%over the past five years. Not to forget, the company does have a high ROE to begin with, just that it is lower than the industry average. Therefore, the shrinking earnings could be the result of other factors. These include low earnings retention or poor allocation of capital.

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 7.8% in the same period. This is quite worrisome.

Earnings growth is a huge factor in stock valuation. 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. If you're wondering about Royalty Pharma's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Royalty Pharma Efficiently Re-investing Its Profits?

With a high three-year median payout ratio of 55% (implying that 45% of the profits are retained), most of Royalty Pharma's profits are being paid to shareholders, which explains the company's shrinking earnings. With only a little being reinvested into the business, earnings growth would obviously be low or non-existent. To know the 2 risks we have identified for Royalty Pharma visit our risks dashboard for free.

Moreover, Royalty Pharma has been paying dividends for five years, which is a considerable amount of time, suggesting that management must have perceived that the shareholders prefer consistent dividends even though earnings have been shrinking. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 17% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 22%, 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 company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.

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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.