Merck (NYSE:MRK) stock is up a significant 6.0% over the past week. Given that the market rewards strong financials over the long term, we wonder if that is the case in this case. Today we will pay particular attention to Merck’s ROE.
Return on equity or ROE is an important factor that a shareholder must consider as it tells them how effectively their capital is being reinvested. In other words, it is a profitability ratio that measures the return on capital provided by the company’s shareholders.
Check out our latest analysis for Merck
How do you calculate return on equity?
Return on equity can be calculated using the formula:
Return on equity = net profit (from continuing operations) ÷ equity
So based on the above formula, the ROE for Merck is:
11% = $4.6 billion ÷ $41 billion (Based on trailing twelve months ending September 2023).
“Return” refers to a company’s profit over the last year. Another way to think of it is that for every dollar of equity, the company was able to generate a profit of $0.11.
What does ROE have to do with earnings growth?
We have already established that ROE serves as an efficient profit-generating measure of a company’s future earnings. Based on how much of its profits the company reinvests or “retains”, we can then evaluate a company’s future ability to generate profits. Assuming everything else remains unchanged, the higher the ROE and profit retention, the higher a company’s growth rate will be compared to companies that don’t necessarily share these characteristics.
A Side-by-Side Comparison of Merck’s Earnings Growth and ROE of 11%
First of all, Merck appears to have a respectable ROE. Furthermore, the company’s ROE of 11% is in line with the industry average. This probably explains, among other things, Merck’s moderate growth of 10% over the last five years.
Next, comparing Merck’s net income growth to the industry, we found that the company’s reported growth is similar to the industry’s average growth rate of 8.5% over the past few years.
Earnings growth is an important factor in stock valuation. It is important for an investor to know whether the market has priced in the company’s expected earnings growth (or decline). This allows them to determine whether the stock’s future looks promising or threatening. Is Merck fairly valued compared to other companies? These 3 evaluation criteria could help you decide.
Does Merck reinvest its profits efficiently?
While Merck has a three-year average payout ratio of 64% (meaning the company retains 36% of profits), the company has still been able to experience significant earnings growth in the past, meaning its high payout ratio has not hindered its ability to do so to grow.
Furthermore, Merck is committed to continuing to share its profits with shareholders, which we infer from its long history of paying dividends for at least ten years. By examining the latest analyst consensus data, we found that the company’s future payout ratio is expected to decline to 39% over the next three years. The expected decline in Merck’s payout ratio therefore explains the expected increase in the company’s future ROE to 37% over the same period.
Overall, we are quite satisfied with Merck’s performance. We’re particularly impressed by the company’s significant earnings growth, which has likely been supported by its high ROE. Even though the company pays out most of its profits as dividends, it has still managed to grow its profits, which is probably a good sign. However, recent analyst forecasts suggest that the company will continue to see earnings growth. Are these analyst expectations based on general industry expectations or on company fundamentals? Click here to go to our analyst forecasts page for the company.
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This article from Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts using only an unbiased methodology and our articles are not intended as financial advice. It does not constitute a recommendation to buy or sell any stock and does not take into account your objectives or financial situation. Our goal is to provide you with long-term focused analysis based on fundamental data. Note that our analysis may not reflect the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.