Most readers would already be aware that Medtronic's (NYSE:MDT) stock increased significantly by 5.5% over the past month. However, in this article, we decided to focus on its weak fundamentals, as long-term financial performance of a business is what ultimately dictates market outcomes. Specifically, we decided to study Medtronic's ROE in this article.

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 Is ROE Calculated?

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 Medtronic is:

8.1% = US$4.2b ÷ US$52b (Based on the trailing twelve months to January 2024).

The 'return' is the yearly profit. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.08 in profit.

What Has ROE Got To Do With Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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 Medtronic's Earnings Growth And 8.1% ROE

When you first look at it, Medtronic's ROE doesn't look that attractive. A quick further study shows that the company's ROE doesn't compare favorably to the industry average of 11% either. Therefore, it might not be wrong to say that the five year net income decline of 2.6% seen by Medtronic was probably the result of it having a lower ROE. We reckon that there could also be other factors at play here. For example, it is possible that the business has allocated capital poorly or that the company has a very high payout ratio.

So, as a next step, we compared Medtronic's performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 9.8% over the last few years.

Earnings growth is an important metric to consider when valuing a stock. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. This then helps them determine if the stock is placed for a bright or bleak future. What is MDT worth today? The intrinsic value infographic in our free research report helps visualize whether MDT is currently mispriced by the market.

Is Medtronic Efficiently Re-investing Its Profits?

With a high three-year median payout ratio of 87% (implying that 13% of the profits are retained), most of Medtronic's profits are being paid to shareholders, which explains the company's shrinking earnings. With only very little left to reinvest into the business, growth in earnings is far from likely.

Moreover, Medtronic has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over earnings growth. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 52% over the next three years. As a result, the expected drop in Medtronic's payout ratio explains the anticipated rise in the company's future ROE to 14%, over the same period.

Summary

Overall, we would be extremely cautious before making any decision on Medtronic. As a result of its low ROE and lack of much reinvestment into the business, the company has seen a disappointing earnings growth rate. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. 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.