Most readers would already be aware that Cachet Pharmaceutical's (SZSE:002462) stock increased significantly by 21% 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. Specifically, we decided to study Cachet Pharmaceutical'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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

See our latest analysis for Cachet Pharmaceutical

How To Calculate Return On Equity?

The formula for ROE is:

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

So, based on the above formula, the ROE for Cachet Pharmaceutical is:

9.1% = CN¥534m ÷ CN¥5.9b (Based on the trailing twelve months to September 2022).

The 'return' is the amount earned after tax over the last twelve months. That means that for every CN¥1 worth of shareholders' equity, the company generated CN¥0.09 in profit.

Why Is ROE Important For Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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 Cachet Pharmaceutical's Earnings Growth And 9.1% ROE

On the face of it, Cachet Pharmaceutical's ROE is not much to talk about. However, its ROE is similar to the industry average of 9.8%, so we won't completely dismiss the company. We can see that Cachet Pharmaceutical has grown at a five year net income growth average rate of 3.9%, which is a bit on the lower side. Remember, the company's ROE is not particularly great to begin with. Hence, this does provide some context to low earnings growth seen by the company.

Next, on comparing with the industry net income growth, we found that Cachet Pharmaceutical's reported growth was lower than the industry growth of 8.9% in the same period, which is not something we like to see.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. This then helps them determine if the stock is placed for a bright or bleak future. 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 Cachet Pharmaceutical is trading on a high P/E or a low P/E, relative to its industry.

Is Cachet Pharmaceutical Making Efficient Use Of Its Profits?

Despite having a moderate three-year median payout ratio of 31% (implying that the company retains the remaining 69% of its income), Cachet Pharmaceutical's earnings growth was quite low. So there could be some other explanation in that regard. For instance, the company's business may be deteriorating.

In addition, Cachet Pharmaceutical has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 24% over the next three years. However, the company's ROE is not expected to change by much despite the lower expected payout ratio.

Summary

In total, we're a bit ambivalent about Cachet Pharmaceutical's performance. While the company does have a high rate of reinvestment, the low ROE means that all that reinvestment is not reaping any benefit to its investors, and moreover, its having a negative impact on the earnings growth. Wrapping up, we would proceed with caution with this company and one way of doing that would be to look at the risk profile of the business. Our risks dashboard would have the 3 risks we have identified for Cachet Pharmaceutical.

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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.