Most readers would already be aware that Novartis' (VTX:NOVN) stock increased significantly by 15% over the past three months. As most would know, fundamentals are what usually guide market price movements over the long-term, so we decided to look at the company's key financial indicators today to determine if they have any role to play in the recent price movement. In this article, we decided to focus on Novartis' 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 other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
How To Calculate Return On Equity?
ROE 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 Novartis is:
13% = US$7.0b ÷ US$52b (Based on the trailing twelve months to March 2023).
The 'return' refers to a company's earnings over the last year. Another way to think of that is that for every CHF1 worth of equity, the company was able to earn CHF0.13 in profit.
Why Is ROE Important For Earnings Growth?
So far, we've learned that ROE is a measure of a company's profitability. Depending on how much of these profits the company reinvests or "retains", and how effectively it does so, we are then able to assess a company’s earnings growth potential. 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.
Novartis' Earnings Growth And 13% ROE
To begin with, Novartis seems to have a respectable ROE. On comparing with the average industry ROE of 10.0% the company's ROE looks pretty remarkable. This certainly adds some context to Novartis' decent 11% net income growth seen over the past five years.
Next, on comparing Novartis' net income growth with the industry, we found that the company's reported growth is similar to the industry average growth rate of 12% 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. Has the market priced in the future outlook for NOVN? You can find out in our latest intrinsic value infographic research report.
Is Novartis Using Its Retained Earnings Effectively?
While Novartis has a three-year median payout ratio of 95% (which means it retains 4.5% of profits), the company has still seen a fair bit of earnings growth in the past, meaning that its high payout ratio hasn't hampered its ability to grow.
Additionally, Novartis has paid dividends over a period of at least ten years which means that the company is pretty serious about sharing its profits with shareholders. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 48% over the next three years. The fact that the company's ROE is expected to rise to 26% over the same period is explained by the drop in the payout ratio.
In total, it does look like Novartis has some positive aspects to its business. Specifically, its high ROE which likely led to the growth in earnings. Bear in mind, the company reinvests little to none of its profits, which means that investors aren't necessarily reaping the full benefits of the high rate of return. On studying current analyst estimates, we found that analysts expect the company to continue its recent growth streak. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.
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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.
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