Most readers would already know that CareTech Holdings' (LON:CTH) stock increased by 7.8% over the past three months. We wonder if and what role the company's financials play in that price change as a company's long-term fundamentals usually dictate market outcomes. In this article, we decided to focus on CareTech Holdings' ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

View our latest analysis for CareTech Holdings

How Is ROE Calculated?

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 CareTech Holdings is:

7.4% = UK£27m ÷ UK£364m (Based on the trailing twelve months to September 2020).

The 'return' is the amount earned after tax over the last twelve months. That means that for every £1 worth of shareholders' equity, the company generated £0.07 in profit.

Why Is ROE Important For 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.

CareTech Holdings' Earnings Growth And 7.4% ROE

At first glance, CareTech Holdings' ROE doesn't look very promising. However, given that the company's ROE is similar to the average industry ROE of 6.9%, we may spare it some thought. Even so, CareTech Holdings has shown a fairly decent growth in its net income which grew at a rate of 8.3%. Given the slightly low ROE, it is likely that there could be some other aspects that are driving this growth. 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 CareTech Holdings' net income growth with the industry and found that the company has a similar growth figure when compared with the industry average growth rate of 7.9% in the same period.

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. Doing so will help them establish if the stock's future looks promising or ominous. Has the market priced in the future outlook for CTH? You can find out in our latest intrinsic value infographic research report.

Is CareTech Holdings Making Efficient Use Of Its Profits?

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

Besides, CareTech Holdings has been paying dividends for at least ten years or more. This shows that the company is committed to sharing profits with its shareholders. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 30% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 13%, over the same period.

Conclusion

Overall, we feel that CareTech Holdings certainly does have some positive factors to consider. While no doubt its earnings growth is pretty substantial, we do feel that the reinvestment rate is pretty low, meaning, the earnings growth number could have been significantly higher had the company been retaining more of its profits. Having said that, looking at the current analyst estimates, we found that the company's earnings are expected to gain momentum. 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.

This article by Simply Wall St is general in nature. 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.

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