Declining Stock and Solid Fundamentals: Is The Market Wrong About Australian Clinical Labs Limited (ASX:ACL)?

It is hard to get excited after looking at Australian Clinical Labs' (ASX:ACL) recent performance, when its stock has declined 21% over the past three months. But if you pay close attention, you might gather that its strong financials could mean that the stock could potentially see an increase in value in the long-term, given how markets usually reward companies with good financial health. In this article, we decided to focus on Australian Clinical Labs' ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

Check out our latest analysis for Australian Clinical Labs

How Is ROE Calculated?

The formula for ROE is:

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

So, based on the above formula, the ROE for Australian Clinical Labs is:

77% = AU$178m ÷ AU$233m (Based on the trailing twelve months to June 2022).

The 'return' is the income the business earned over the last year. Another way to think of that is that for every A$1 worth of equity, the company was able to earn A$0.77 in profit.

What Is The Relationship Between ROE And Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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. 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.

Australian Clinical Labs' Earnings Growth And 77% ROE

First thing first, we like that Australian Clinical Labs has an impressive ROE. Secondly, even when compared to the industry average of 7.2% the company's ROE is quite impressive. As a result, Australian Clinical Labs' exceptional 49% net income growth seen over the past five years, doesn't come as a surprise.

As a next step, we compared Australian Clinical Labs' net income growth with the industry, and pleasingly, we found that the growth seen by the company is higher than the average industry growth of 10%.

past-earnings-growth
past-earnings-growth

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. Is Australian Clinical Labs fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Australian Clinical Labs Using Its Retained Earnings Effectively?

Australian Clinical Labs has a three-year median payout ratio of 37% (where it is retaining 63% of its income) which is not too low or not too high. So it seems that Australian Clinical Labs is reinvesting efficiently in a way that it sees impressive growth in its earnings (discussed above) and pays a dividend that's well covered.

While Australian Clinical Labs has seen growth in its earnings, it only recently started to pay a dividend. It is most likely that the company decided to impress new and existing shareholders with a dividend. Looking at the current analyst consensus data, we can see that the company's future payout ratio is expected to rise to 57% over the next three years. Therefore, the expected rise in the payout ratio explains why the company's ROE is expected to decline to 19% over the same period.

Summary

In total, we are pretty happy with Australian Clinical Labs' performance. In particular, it's great to see that the company is investing heavily into its business and along with a high rate of return, that has resulted in a sizeable growth in its earnings. That being so, according to the latest industry analyst forecasts, the company's earnings are expected to shrink in the future. 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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