Capitol Health's (ASX:CAJ) stock is up by a considerable 13% over the past three months. We wonder if and what role the company's financials play in that price change as a company's long-term fundamentals usually dictate market outcomes. Specifically, we decided to study Capitol Health's ROE in this article.

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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.

Check out our latest analysis for Capitol Health

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 Capitol Health is:

8.2% = AU$12m ÷ AU$146m (Based on the trailing twelve months to June 2021).

The 'return' is the profit over the last twelve months. One way to conceptualize this is that for each A$1 of shareholders' capital it has, the company made A$0.08 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. Depending on how much of these profits the company reinvests or "retains", and how effectively it does so, we are then able to assess a company’s earnings growth potential. 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.

Capitol Health's Earnings Growth And 8.2% ROE

At first glance, Capitol Health's ROE doesn't look very promising. A quick further study shows that the company's ROE doesn't compare favorably to the industry average of 13% either. However, we we're pleasantly surprised to see that Capitol Health grew its net income at a significant rate of 30% in the last five years. So, there might be other aspects that are positively influencing the company's earnings growth. For instance, the company has a low payout ratio or is being managed efficiently.

As a next step, we compared Capitol Health's net income growth with the industry, and pleasingly, we found that the growth seen by the company is higher than the average industry growth of 3.8%.

Earnings growth is a huge factor in stock valuation. 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. If you're wondering about Capitol Health's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Capitol Health Using Its Retained Earnings Effectively?

Capitol Health's three-year median payout ratio is a pretty moderate 40%, meaning the company retains 60% of its income. So it seems that Capitol Health is reinvesting efficiently in a way that it sees impressive growth in its earnings (discussed above) and pays a dividend that's well covered.

Moreover, Capitol Health is determined to keep sharing its profits with shareholders which we infer from its long history of nine years of paying a dividend. Looking at the current analyst consensus data, we can see that the company's future payout ratio is expected to rise to 73% over the next three years. Still, forecasts suggest that Capitol Health's future ROE will rise to 12% even though the the company's payout ratio is expected to rise. We presume that there could some other characteristics of the business that could be driving the anticipated growth in the company's ROE.

Conclusion

Overall, we feel that Capitol Health certainly does have some positive factors to consider. With a high rate of reinvestment, albeit at a low ROE, the company has managed to see a considerable growth in its earnings. With that said, the latest industry analyst forecasts reveal that the company's earnings growth is expected to slow down. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.

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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