Royalty Pharma (NASDAQ:RPRX) has had a rough three months with its share price down 8.9%. However, stock prices are usually driven by a company's financials over the long term, which in this case look pretty respectable. Particularly, we will be paying attention to Royalty Pharma's ROE today.

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

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 Royalty Pharma is:

12% = US$1.2b ÷ US$9.9b (Based on the trailing twelve months to March 2024).

The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.12 in profit.

What Is The Relationship Between ROE And Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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.

Royalty Pharma's Earnings Growth And 12% ROE

At first glance, Royalty Pharma seems to have a decent ROE. Further, the company's ROE is similar to the industry average of 14%. For this reason, Royalty Pharma's five year net income decline of 41% raises the question as to why the decent ROE didn't translate into growth. We reckon that there could be some other factors at play here that are preventing the company's growth. These include low earnings retention or poor allocation of capital.

Furthermore, even when compared to the industry, which has been shrinking its earnings at a rate of 0.4% over the last few years, we found that Royalty Pharma's performance is pretty disappointing, as it suggests that the company has been shrunk its earnings at a rate faster than the industry.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. One good indicator of expected earnings growth is the P/E ratio which determines the price the market is willing to pay for a stock based on its earnings prospects. So, you may want to check if Royalty Pharma is trading on a high P/E or a low P/E, relative to its industry.

Is Royalty Pharma Efficiently Re-investing Its Profits?

Despite having a normal three-year median payout ratio of 49% (where it is retaining 51% of its profits), Royalty Pharma has seen a decline in earnings as we saw above. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.

Moreover, Royalty Pharma has been paying dividends for four years, which is a considerable amount of time, suggesting that management must have perceived that the shareholders prefer consistent dividends even though earnings have been shrinking. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 20% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 26%, over the same period.

Conclusion

Overall, we feel that Royalty Pharma certainly does have some positive factors to consider. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE and and a high reinvestment rate. We believe that there might be some outside factors that could be having a negative impact on the business. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts 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.