It is hard to get excited after looking at West Pharmaceutical Services' (NYSE:WST) recent performance, when its stock has declined 11% over the past month. However, stock prices are usually driven by a company’s financial performance over the long term, which in this case looks quite promising. Particularly, we will be paying attention to West Pharmaceutical Services' ROE today.

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.

Check out our latest analysis for West Pharmaceutical Services

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 West Pharmaceutical Services is:

28% = US$613m ÷ US$2.2b (Based on the trailing twelve months to September 2021).

The 'return' refers to a company's earnings over the last year. That means that for every $1 worth of shareholders' equity, the company generated $0.28 in profit.

What Is The Relationship Between ROE And Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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.

A Side By Side comparison of West Pharmaceutical Services' Earnings Growth And 28% ROE

Firstly, we acknowledge that West Pharmaceutical Services has a significantly high ROE. Additionally, the company's ROE is higher compared to the industry average of 16% which is quite remarkable. So, the substantial 28% net income growth seen by West Pharmaceutical Services over the past five years isn't overly surprising.

We then performed a comparison between West Pharmaceutical Services' net income growth with the industry, which revealed that the company's growth is similar to the average industry growth of 32% in the same period.

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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. If you're wondering about West Pharmaceutical Services''s valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is West Pharmaceutical Services Efficiently Re-investing Its Profits?

West Pharmaceutical Services' ' three-year median payout ratio is on the lower side at 18% implying that it is retaining a higher percentage (82%) of its profits. So it looks like West Pharmaceutical Services is reinvesting profits heavily to grow its business, which shows in its earnings growth.

Additionally, West Pharmaceutical Services 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 9.0% over the next three years. Regardless, the future ROE for West Pharmaceutical Services is predicted to decline to 19% despite the anticipated decrease in the payout ratio. We reckon that there could probably be other factors that could be driving the forseen decline in the company's ROE.

Conclusion

On the whole, we feel that West Pharmaceutical Services' performance has been quite good. Particularly, we like that the company is reinvesting heavily into its business, and at a high rate of return. Unsurprisingly, this has led to an impressive earnings growth. 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.

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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.