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Alliance Pharma's (LON:APH) stock up by 9.1% 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 In this article, we decided to focus on Alliance Pharma's ROE.
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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.
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 Alliance Pharma is:
2.9% = UK£8.0m ÷ UK£281m (Based on the trailing twelve months to December 2020).
The 'return' is the yearly profit. So, this means that for every £1 of its shareholder's investments, the company generates a profit of £0.03.
What Has ROE Got To Do With 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.
A Side By Side comparison of Alliance Pharma's Earnings Growth And 2.9% ROE
It is quite clear that Alliance Pharma's ROE is rather low. Even when compared to the industry average of 19%, the ROE figure is pretty disappointing. Given the circumstances, the significant decline in net income by 3.8% seen by Alliance Pharma over the last five years is not surprising. We reckon that there could also be other factors at play here. For instance, the company has a very high payout ratio, or is faced with competitive pressures.
However, when we compared Alliance 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 6.0% 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. Has the market priced in the future outlook for APH? You can find out in our latest intrinsic value infographic research report.
Is Alliance Pharma Making Efficient Use Of Its Profits?
Looking at its three-year median payout ratio of 27% (or a retention ratio of 73%) which is pretty normal, Alliance 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. It looks like there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.
In addition, Alliance Pharma has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 27%. Still, forecasts suggest that Alliance Pharma's future ROE will rise to 11% even though the the company's payout ratio is not expected to change by much.
Overall, we have mixed feelings about Alliance Pharma. 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. That being so, the latest industry analyst forecasts show that the analysts are expecting to see a huge improvement in the company's earnings growth rate. 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.
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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