Should Weakness in The Eastern Company's (NASDAQ:EML) Stock Be Seen As A Sign That Market Will Correct The Share Price Given Decent Financials?

·4 min read

It is hard to get excited after looking at Eastern's (NASDAQ:EML) recent performance, when its stock has declined 16% over the past three months. However, the company's fundamentals look pretty decent, and long-term financials are usually aligned with future market price movements. Specifically, we decided to study Eastern'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. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

See our latest analysis for Eastern

How Do You Calculate Return On Equity?

Return on equity 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 Eastern is:

8.5% = US$9.1m ÷ US$107m (Based on the trailing twelve months to July 2021).

The 'return' refers to a company's earnings over the last year. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.09 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.

Eastern's Earnings Growth And 8.5% ROE

When you first look at it, Eastern's ROE doesn't look that attractive. We then compared the company's ROE to the broader industry and were disappointed to see that the ROE is lower than the industry average of 11%. However, the moderate 9.2% net income growth seen by Eastern over the past five years is definitely a positive. We reckon that there could be other factors at play here. 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.

As a next step, we compared Eastern's net income growth with the industry and found that the company has a similar growth figure when compared with the industry average growth rate of 8.2% in the same period.

past-earnings-growth
past-earnings-growth

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). 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 Eastern is trading on a high P/E or a low P/E, relative to its industry.

Is Eastern Using Its Retained Earnings Effectively?

In Eastern's case, its respectable earnings growth can probably be explained by its low three-year median payout ratio of 22% (or a retention ratio of 78%), which suggests that the company is investing most of its profits to grow its business.

Additionally, Eastern 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.

Conclusion

In total, it does look like Eastern has some positive aspects to its business. Despite its low rate of return, the fact that the company reinvests a very high portion of its profits into its business, no doubt contributed to its high earnings growth. While we won't completely dismiss the company, what we would do, is try to ascertain how risky the business is to make a more informed decision around the company. You can see the 4 risks we have identified for Eastern by visiting our risks dashboard for free on our platform here.

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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