It is hard to get excited after looking at Merck's (NYSE:MRK) recent performance, when its stock has declined 13% over the past three months. However, stock prices are usually driven by a company’s financials over the long term, which in this case look pretty respectable. In this article, we decided to focus on Merck's ROE.

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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.

See our latest analysis for Merck

How Is ROE Calculated?

The formula for ROE is:

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

So, based on the above formula, the ROE for Merck is:

32% = US$14b ÷ US$44b (Based on the trailing twelve months to June 2024).

The 'return' is the income the business earned over the last year. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.32.

Why Is ROE Important For Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. 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.

A Side By Side comparison of Merck's Earnings Growth And 32% ROE

To begin with, Merck has a pretty high ROE which is interesting. Additionally, the company's ROE is higher compared to the industry average of 22% which is quite remarkable. Despite this, Merck's five year net income growth was quite flat over the past five years. We reckon that there could be some other factors at play here that's limiting the company's growth. These include low earnings retention or poor allocation of capital

Next, when we compared with the industry, which has shrunk its earnings at a rate of 0.3% in the same 5-year period, we still found Merck's performance to be quite bleak, because the company has been shrinking its earnings faster than the industry.

Earnings growth is a huge factor in stock valuation. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. Doing so will help them establish if the stock's future looks promising or ominous. If you're wondering about Merck's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Merck Making Efficient Use Of Its Profits?

The high three-year median payout ratio of 55% (meaning, the company retains only 45% of profits) for Merck suggests that the company's earnings growth was miniscule as a result of paying out a majority of its earnings.

Moreover, Merck 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. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 32% over the next three years. The fact that the company's ROE is expected to rise to 40% over the same period is explained by the drop in the payout ratio.

Summary

On the whole, we do feel that Merck has some positive attributes. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE. Bear in mind, the company reinvests a small portion of its profits, which means that investors aren't reaping the benefits of the high rate of return. 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. 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.

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

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.