It is hard to get excited after looking at West Pharmaceutical Services' (NYSE:WST) recent performance, when its stock has declined 8.2% over the past three months. However, a closer look at its sound financials might cause you to think again. Given that fundamentals usually drive long-term market outcomes, the company is worth looking at. Particularly, we will be paying attention to West Pharmaceutical Services' ROE today.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

How Do You Calculate Return On Equity?

The formula for ROE is:

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

So, based on the above formula, the ROE for West Pharmaceutical Services is:

21% = US$569m ÷ US$2.7b (Based on the trailing twelve months to March 2024).

The 'return' is the amount earned after tax over the last twelve months. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.21.

What Has ROE Got To Do With 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. 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 West Pharmaceutical Services' Earnings Growth And 21% ROE

To start with, West Pharmaceutical Services' ROE looks acceptable. Especially when compared to the industry average of 13% the company's ROE looks pretty impressive. This probably laid the ground for West Pharmaceutical Services' moderate 20% net income growth seen over the past five years.

We then performed a comparison between West Pharmaceutical Services' net income growth with the industry, which revealed that the company's growth is similar to the average industry growth of 17% 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 West Pharmaceutical Services fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is West Pharmaceutical Services Making Efficient Use Of Its Profits?

In West Pharmaceutical Services' case, its respectable earnings growth can probably be explained by its low three-year median payout ratio of 9.5% (or a retention ratio of 90%), which suggests that the company is investing most of its profits to grow its business.

Moreover, West Pharmaceutical Services 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. Looking at the current analyst consensus data, we can see that the company's future payout ratio is expected to rise to 16% over the next three years. Accordingly, the expected increase in the payout ratio explains the expected decline in the company's ROE to 14%, over the same period.

Conclusion

Overall, we are quite pleased with West Pharmaceutical Services' 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. That being so, a study of the latest analyst forecasts show that the company is expected to see a slowdown in its future earnings growth. 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.