Royalty Pharma (NASDAQ:RPRX) has had a rough three months with its share price down 13%. However, stock prices are usually driven by a company’s financials over the long term, which in this case look pretty respectable. In this article, we decided to focus on Royalty Pharma's ROE.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Put another way, it reveals the company's success at turning shareholder investments into profits.
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 Royalty Pharma is:
18% = US$1.8b ÷ US$9.8b (Based on the trailing twelve months to March 2021).
The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.18 in profit.
Why Is ROE Important For Earnings Growth?
We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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 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.
A Side By Side comparison of Royalty Pharma's Earnings Growth And 18% ROE
To begin with, Royalty Pharma seems to have a respectable ROE. Further, the company's ROE is similar to the industry average of 21%. As you might expect, the 7.7% net income decline reported by Royalty Pharma is a bit of a surprise. So, there might be some other aspects that could explain this. For example, it could be that the company has a high payout ratio or the business has allocated capital poorly, for instance.
That being said, we compared Royalty Pharma's performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 21% in the same period.
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. This then helps them determine if the stock is placed for a bright or bleak future. One good indicator of expected earnings growth is the P/E ratio which determines the price the market is willing to pay for a stock based on its earnings prospects. So, you may want to check if Royalty Pharma is trading on a high P/E or a low P/E, relative to its industry.
Is Royalty Pharma Using Its Retained Earnings Effectively?
Royalty Pharma's low three-year median payout ratio of 23% (implying that it retains the remaining 77% of its profits) comes as a surprise when you pair it with the shrinking earnings. The low payout should mean that the company is retaining most of its earnings and consequently, should see some growth. It looks like there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.
Additionally, Royalty Pharma started paying a dividend only recently. So it looks like the management may have perceived that shareholders favor dividends even though earnings have been in decline. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 23% of its profits over the next three years. Regardless, the future ROE for Royalty Pharma is predicted to rise to 23% despite there being not much change expected in its payout ratio.
Overall, we feel that Royalty Pharma certainly does have some positive factors to consider. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE and and a high reinvestment rate. We believe that there might be some outside factors that could be having a negative impact on the business. 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. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.
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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