Most readers would already be aware that Analog Devices' (NASDAQ:ADI) stock increased significantly by 17% over the past three months. But the company's key financial indicators appear to be differing across the board and that makes us question whether or not the company's current share price momentum can be maintained. Particularly, we will be paying attention to Analog Devices' ROE today.

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.

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 Analog Devices is:

6.1% = US$2.1b ÷ US$35b (Based on the trailing twelve months to May 2024).

The 'return' is the yearly profit. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.06.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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 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.

Analog Devices' Earnings Growth And 6.1% ROE

When you first look at it, Analog Devices' ROE doesn't look that attractive. Next, when compared to the average industry ROE of 15%, the company's ROE leaves us feeling even less enthusiastic. In spite of this, Analog Devices was able to grow its net income considerably, at a rate of 22% in the last five years. So, there might be other aspects that are positively influencing the company's earnings growth. For example, it is possible that the company's management has made some good strategic decisions, or that the company has a low payout ratio.

Next, on comparing with the industry net income growth, we found that Analog Devices' reported growth was lower than the industry growth of 31% over the last few years, which is not something we like to see.

Earnings growth is a huge factor in stock valuation. It's important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). This then helps them determine if the stock is placed for a bright or bleak future. What is ADI worth today? The intrinsic value infographic in our free research report helps visualize whether ADI is currently mispriced by the market.

Is Analog Devices Using Its Retained Earnings Effectively?

Analog Devices' significant three-year median payout ratio of 60% (where it is retaining only 40% of its income) suggests that the company has been able to achieve a high growth in earnings despite returning most of its income to shareholders.

Besides, Analog Devices has been paying dividends for at least ten years or more. This shows that the company is committed to sharing profits with its shareholders. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 42% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 16%, over the same period.

Summary

In total, we're a bit ambivalent about Analog Devices' performance. Although the company has shown a fair bit of growth in earnings, the reinvestment rate is low. Meaning, the earnings growth number could have been significantly higher had the company been retaining more of its profits and reinvesting that at a higher rate of return. On studying current analyst estimates, we found that analysts expect the company to continue its recent growth streak. 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.

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