NeoPhotonics Corporation (NYSE:NPTN) Is Going Strong But Fundamentals Appear To Be Mixed : Is There A Clear Direction For The Stock?

NeoPhotonics (NYSE:NPTN) has had a great run on the share market with its stock up by a significant 18% over the last month. 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. Particularly, we will be paying attention to NeoPhotonics' ROE today.

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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

Check out our latest analysis for NeoPhotonics

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 NeoPhotonics is:

5.1% = US$9.2m ÷ US$182m (Based on the trailing twelve months to September 2020).

The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.05 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. 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. Assuming all else is equal, companies that have both a higher return on equity and higher profit retention are usually the ones that have a higher growth rate when compared to companies that don't have the same features.

NeoPhotonics' Earnings Growth And 5.1% ROE

At first glance, NeoPhotonics' ROE doesn't look very promising. We then compared the company's ROE to the broader industry and were disappointed to see that the ROE is lower than the industry average of 11%. Therefore, it might not be wrong to say that the five year net income decline of 11% seen by NeoPhotonics was probably the result of it having a lower ROE. We believe that there also might be other aspects that are negatively influencing the company's earnings prospects. Such as - low earnings retention or poor allocation of capital.

However, when we compared NeoPhotonics' growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 16% in the same period. This is quite worrisome.

Earnings growth is an important metric to consider when valuing a stock. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. Doing so will help them establish if the stock's future looks promising or ominous. If you're wondering about NeoPhotonics''s valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is NeoPhotonics Using Its Retained Earnings Effectively?

Conclusion

Overall, we have mixed feelings about NeoPhotonics. Even though it appears to be retaining most of its profits, given the low ROE, investors may not be benefitting from all that reinvestment after all. The low earnings growth suggests our theory correct. In addition, on studying the latest analyst forecasts, we found that the company's earnings are expected to continue to shrink. 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. 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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