Merck & Co., Inc.'s (NYSE:MRK) Stock Has Been Sliding But Fundamentals Look Strong: Is The Market Wrong?

Merck (NYSE:MRK) has had a rough three months with its share price down 5.6%. However, stock prices are usually driven by a company’s financial performance over the long term, which in this case looks quite promising. Particularly, we will be paying attention to Merck's ROE today.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

View our latest analysis for Merck

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 Merck is:

27% = US$12b ÷ US$45b (Based on the trailing twelve months to September 2024).

The 'return' is the amount earned after tax over the last twelve months. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.27 in profit.

Why Is ROE Important For Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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.

Merck's Earnings Growth And 27% ROE

Firstly, we acknowledge that Merck has a significantly high ROE. Second, a comparison with the average ROE reported by the industry of 19% also doesn't go unnoticed by us. Despite this, Merck's five year net income growth was quite low averaging at only 2.1%. That's a bit unexpected from a company which has such a high rate of return. We reckon that a low growth, when returns are quite high could be the result of certain circumstances like low earnings retention or or poor allocation of capital.

Next, on comparing with the industry net income growth, we found that Merck's growth is quite high when compared to the industry average growth of 1.2% in the same period, which is great to see.

Earnings growth is a huge factor in stock valuation. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is Merck fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Merck Efficiently Re-investing Its Profits?

The high three-year median payout ratio of 55% (that is, the company retains only 45% of its income) over the past three years for Merck suggests that the company's earnings growth was lower as a result of paying out a majority of its earnings.

Additionally, Merck has paid dividends over a period of at least ten years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 33% over the next three years. As a result, the expected drop in Merck's payout ratio explains the anticipated rise in the company's future ROE to 35%, over the same period.

Conclusion

On the whole, we feel that Merck's performance has been quite good. In particular, its high ROE is quite noteworthy and also the probable explanation behind its considerable earnings growth. Yet, the company is retaining a small portion of its profits. Which means that the company has been able to grow its earnings in spite of it, so that's not too bad. That being so, the latest analyst forecasts show that the company will continue to see an expansion in its earnings. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.