Probiotec's (ASX:PBP) stock up by 6.5% over the past three months. However, the company's financials look a bit inconsistent and market outcomes are ultimately driven by long-term fundamentals, meaning that the stock could head in either direction. Particularly, we will be paying attention to Probiotec's ROE today.

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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

See our latest analysis for Probiotec

How To 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 Probiotec is:

7.4% = AU$5.1m ÷ AU$69m (Based on the trailing twelve months to June 2021).

The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each A$1 of shareholders' capital it has, the company made A$0.07 in profit.

What Has ROE Got To Do With Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. 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.

Probiotec's Earnings Growth And 7.4% ROE

On the face of it, Probiotec's ROE is not much to talk about. We then compared the company's ROE to the broader industry and were disappointed to see that the ROE is lower than the industry average of 24%. Although, we can see that Probiotec saw a modest net income growth of 20% over the past five years. We reckon that there could be other factors at play here. For example, it is possible that the company's management has made some good strategic decisions, or that the company has a low payout ratio.

As a next step, we compared Probiotec's net income growth with the industry and were disappointed to see that the company's growth is lower than the industry average growth of 29% in the same period.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. If you're wondering about Probiotec's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Probiotec Efficiently Re-investing Its Profits?

The high three-year median payout ratio of 56% (or a retention ratio of 44%) for Probiotec suggests that the company's growth wasn't really hampered despite it returning most of its income to its shareholders.

Moreover, Probiotec is determined to keep sharing its profits with shareholders which we infer from its long history of five years of paying a dividend. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 45% over the next three years. As a result, the expected drop in Probiotec's payout ratio explains the anticipated rise in the company's future ROE to 18%, over the same period.

Summary

In total, we're a bit ambivalent about Probiotec's performance. Although the company has shown a fair bit of growth in earnings, the reinvestment rate is low. Meaning, the earnings growth number could have been significantly higher had the company been retaining more of its profits and reinvesting that at a higher rate of return. That being so, the latest analyst forecasts show that the company will continue to see an expansion in its earnings. 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.