Does The Market Have A Low Tolerance For Compumedics Limited's (ASX:CMP) Mixed Fundamentals?

Compumedics (ASX:CMP) has had a rough three months with its share price down 20%. We, however decided to study the company's financials to determine if they have got anything to do with the price decline. Fundamentals usually dictate market outcomes so it makes sense to study the company's financials. In this article, we decided to focus on Compumedics' ROE.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. Put another way, it reveals the company's success at turning shareholder investments into profits.

View our latest analysis for Compumedics

How Do You Calculate Return On Equity?

Return on equity 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 Compumedics is:

5.8% = AU$1.4m ÷ AU$24m (Based on the trailing twelve months to June 2022).

The 'return' is the income the business earned over the last year. So, this means that for every A$1 of its shareholder's investments, the company generates a profit of A$0.06.

Why Is ROE Important For Earnings Growth?

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

Compumedics' Earnings Growth And 5.8% ROE

When you first look at it, Compumedics' ROE doesn't look that attractive. Next, when compared to the average industry ROE of 9.4%, the company's ROE leaves us feeling even less enthusiastic. For this reason, Compumedics' five year net income decline of 31% is not surprising given its lower ROE. However, there could also be other factors causing the earnings to decline. For instance, the company has a very high payout ratio, or is faced with competitive pressures.

Furthermore, even when compared to the industry, which has been shrinking its earnings at a rate 0.5% in the same period, we found that Compumedics' performance is pretty disappointing, as it suggests that the company has been shrunk its earnings at a rate faster than the industry.

Earnings growth is an important metric to consider when valuing a stock. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. Doing so will help them establish if the stock's future looks promising or ominous. 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 Compumedics is trading on a high P/E or a low P/E, relative to its industry.

Is Compumedics Making Efficient Use Of Its Profits?

Compumedics doesn't pay any dividend, meaning that the company is keeping all of its profits, which makes us wonder why it is retaining its earnings if it can't use them to grow its business. So there could be some other explanations in that regard. For instance, the company's business may be deteriorating.

Summary

Overall, we have mixed feelings about Compumedics. Even though it appears to be retaining most of its profits, given the low ROE, investors may not be benefitting from all that reinvestment after all. The low earnings growth suggests our theory correct. Wrapping up, we would proceed with caution with this company and one way of doing that would be to look at the risk profile of the business. To know the 3 risks we have identified for Compumedics visit our risks dashboard for free.

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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