Monolithic Power Systems' (NASDAQ:MPWR) stock is up by a considerable 26% over the past three months. Given that the market rewards strong financials in the long-term, we wonder if that is the case in this instance. In this article, we decided to focus on Monolithic Power Systems' ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors' money. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

How To Calculate Return On Equity?

The formula for return on equity is:

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

So, based on the above formula, the ROE for Monolithic Power Systems is:

19% = US$411m ÷ US$2.2b (Based on the trailing twelve months to June 2024).

The 'return' is the income the business earned over the last year. That means that for every $1 worth of shareholders' equity, the company generated $0.19 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. 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. 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.

A Side By Side comparison of Monolithic Power Systems' Earnings Growth And 19% ROE

At first glance, Monolithic Power Systems seems to have a decent ROE. Further, the company's ROE compares quite favorably to the industry average of 14%. Probably as a result of this, Monolithic Power Systems was able to see an impressive net income growth of 31% over the last five years. However, there could also be other causes behind this growth. Such as - high earnings retention or an efficient management in place.

We then performed a comparison between Monolithic Power Systems' net income growth with the industry, which revealed that the company's growth is similar to the average industry growth of 29% in the same 5-year period.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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. Is Monolithic Power Systems fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Monolithic Power Systems Efficiently Re-investing Its Profits?

Monolithic Power Systems has a three-year median payout ratio of 43% (where it is retaining 57% of its income) which is not too low or not too high. By the looks of it, the dividend is well covered and Monolithic Power Systems is reinvesting its profits efficiently as evidenced by its exceptional growth which we discussed above.

Additionally, Monolithic Power Systems 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. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 23% over the next three years. As a result, the expected drop in Monolithic Power Systems' payout ratio explains the anticipated rise in the company's future ROE to 30%, over the same period.

Conclusion

In total, we are pretty happy with Monolithic Power Systems' performance. Specifically, we like that the company is reinvesting a huge chunk of its profits at a high rate of return. This of course has caused the company to see substantial growth in its earnings. Having said that, the company's earnings growth is expected to slow down, as forecasted in the current analyst estimates. 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.