Microchip Technology's (NASDAQ:MCHP) stock is up by 9.0% over the past three months. Given that the market rewards strong financials in the long-term, we wonder if that is the case in this instance. Specifically, we decided to study Microchip Technology's ROE in this article.

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. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

How Is ROE Calculated?

ROE 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 Microchip Technology is:

29% = US$1.9b ÷ US$6.7b (Based on the trailing twelve months to March 2024).

The 'return' is the amount earned after tax over the last twelve months. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.29 in profit.

What Has ROE Got To Do With Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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 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.

A Side By Side comparison of Microchip Technology's Earnings Growth And 29% ROE

Firstly, we acknowledge that Microchip Technology has a significantly high ROE. Second, a comparison with the average ROE reported by the industry of 15% also doesn't go unnoticed by us. So, the substantial 40% 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 30% in the same 5-year 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. This then helps them determine if the stock is placed for a bright or bleak future. Is Microchip Technology fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Microchip Technology Using Its Retained Earnings Effectively?

Microchip Technology's three-year median payout ratio is a pretty moderate 37%, meaning the company retains 63% of its income. So it seems that Microchip Technology is reinvesting efficiently in a way that it sees impressive growth in its earnings (discussed above) and pays a dividend that's well covered.

Moreover, Microchip Technology is determined to keep sharing its profits with shareholders which we infer from its long history of paying a dividend for at least ten years. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 43% of its profits over the next three years. Regardless, the future ROE for Microchip Technology is predicted to rise to 49% despite there being not much change expected in its payout ratio.

Summary

Overall, we are quite pleased with Microchip Technology's performance. Particularly, we like that the company is reinvesting heavily into its business, and at a high rate of return. Unsurprisingly, this has led to an impressive earnings growth. 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.

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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.