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CVS Health (NYSE:CVS) has had a rough three months with its share price down 6.1%. However, a closer look at its sound financials might cause you to think again. Given that fundamentals usually drive long-term market outcomes, the company is worth looking at. In this article, we decided to focus on CVS Health'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. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.
How Is ROE Calculated?
Return on equity can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for CVS Health is:
11% = US$8.0b ÷ US$74b (Based on the trailing twelve months to March 2022).
The 'return' is the amount earned after tax over the last twelve months. That means that for every $1 worth of shareholders' equity, the company generated $0.11 in profit.
What Has ROE Got To Do With 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.
A Side By Side comparison of CVS Health's Earnings Growth And 11% ROE
To start with, CVS Health's ROE looks acceptable. Yet, the fact that the company's ROE is lower than the industry average of 15% does temper our expectations. Although, we can see that CVS Health saw a modest net income growth of 15% over the past five years. Therefore, the growth in earnings could probably have been caused by other variables. For instance, the company has a low payout ratio or is being managed efficiently. However, not to forget, the company does have a decent ROE to begin with, just that it is lower than the industry average. So this also does lend some color to the fairly high earnings growth seen by the company.
We then performed a comparison between CVS Health's net income growth with the industry, which revealed that the company's growth is similar to the average industry growth of 19% in the same period.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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 CVS Health fairly valued compared to other companies? These 3 valuation measures might help you decide.
Is CVS Health Making Efficient Use Of Its Profits?
CVS Health has a healthy combination of a moderate three-year median payout ratio of 35% (or a retention ratio of 65%) and a respectable amount of growth in earnings as we saw above, meaning that the company has been making efficient use of its profits.
Moreover, CVS Health is determined to keep sharing its profits with shareholders which we infer from its long history of paying a dividend for at least ten years. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 23% over the next three years. The fact that the company's ROE is expected to rise to 16% over the same period is explained by the drop in the payout ratio.
On the whole, we feel that CVS Health's performance has been quite good. Particularly, we like that the company is reinvesting heavily into its business at a moderate rate of return. Unsurprisingly, this has led to an impressive earnings growth. Having said that, the company's earnings growth is expected to slow down, as forecasted in the current analyst estimates. 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.