West Pharmaceutical Services (NYSE:WST) has had a rough three months with its share price down 18%. But if you pay close attention, you might gather that its strong financials could mean that the stock could potentially see an increase in value in the long-term, given how markets usually reward companies with good financial health. Specifically, we decided to study West Pharmaceutical Services' 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. Put another way, it reveals the company's success at turning shareholder investments into profits.

How To Calculate Return On Equity?

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 West Pharmaceutical Services is:

20% = US$525m ÷ US$2.6b (Based on the trailing twelve months to June 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 $0.20 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. 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. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don't share these attributes.

West Pharmaceutical Services' Earnings Growth And 20% ROE

To start with, West Pharmaceutical Services' ROE looks acceptable. On comparing with the average industry ROE of 12% the company's ROE looks pretty remarkable. This certainly adds some context to West Pharmaceutical Services' decent 17% net income growth seen over the past five years.

Next, on comparing West Pharmaceutical Services' net income growth with the industry, we found that the company's reported growth is similar to the industry average growth rate of 16% over the last few years.

Earnings growth is an important metric to consider when valuing a stock. It's important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). Doing so will help them establish if the stock's future looks promising or ominous. What is WST worth today? The intrinsic value infographic in our free research report helps visualize whether WST is currently mispriced by the market.

Is West Pharmaceutical Services Using Its Retained Earnings Effectively?

West Pharmaceutical Services' three-year median payout ratio to shareholders is 9.5% (implying that it retains 90% of its income), which is on the lower side, so it seems like the management is reinvesting profits heavily to grow its business.

Additionally, West Pharmaceutical Services has paid dividends over a period of at least ten years which means that the company is pretty serious about sharing its profits with shareholders. 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. Regardless, the ROE is not expected to change much for the company despite the higher expected payout ratio.

Conclusion

In total, we are pretty happy 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. Having said that, the company's earnings growth is expected to slow down, as forecasted in the current analyst estimates. 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.

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