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Are Robust Financials Driving The Recent Rally In Microchip Technology Incorporated's (NASDAQ:MCHP) Stock?

Microchip Technology's (NASDAQ:MCHP) stock is up by a considerable 7.3% over the past month. Given that the market rewards strong financials in the long-term, we wonder if that is the case in this instance. Particularly, we will be paying attention to Microchip Technology's ROE today.

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

View our latest analysis for Microchip Technology

How Do You Calculate Return On Equity?

ROE can be calculated by using the formula:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

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So, based on the above formula, the ROE for Microchip Technology is:

34% = US$2.2b ÷ US$6.5b (Based on the trailing twelve months to March 2023).

The 'return' is the income the business earned over the last year. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.34 in profit.

What Is The Relationship Between ROE And Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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.

Microchip Technology's Earnings Growth And 34% ROE

Firstly, we acknowledge that Microchip Technology has a significantly high ROE. Additionally, the company's ROE is higher compared to the industry average of 16% which is quite remarkable. So, the substantial 47% net income growth seen by Microchip Technology over the past five years isn't overly surprising.

We then compared Microchip Technology's net income growth with the industry and we're pleased to see that the company's growth figure is higher when compared with the industry which has a growth rate of 32% in the same period.

past-earnings-growth
past-earnings-growth

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. Is Microchip Technology fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Microchip Technology Making Efficient Use Of Its Profits?

The high three-year median payout ratio of 55% (implying that it keeps only 45% of profits) for Microchip Technology suggests that the company's growth wasn't really hampered despite it returning most of the earnings to its shareholders.

Additionally, Microchip Technology 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 36% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 51%, over the same period.

Summary

In total, we are pretty happy with Microchip Technology's performance. We are particularly impressed by the considerable earnings growth posted by the company, which was likely backed by its high ROE. While the company is paying out most of its earnings as dividends, it has been able to grow its earnings in spite of it, so that's probably a good sign. Having said that, the company's earnings growth is expected to slow down, as forecasted in the current analyst estimates. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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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