Cochlear (ASX:COH) has had a rough three months with its share price down 16%. But if you pay close attention, you might gather that its strong financials could mean that the stock could potentially see an increase in value in the long-term, given how markets usually reward companies with good financial health. Specifically, we decided to study Cochlear's ROE in this article.

ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

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How Is ROE Calculated?

ROE 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 Cochlear is:

20% = AU$371m ÷ AU$1.9b (Based on the trailing twelve months to December 2024).

The 'return' refers to a company's earnings over the last year. That means that for every A$1 worth of shareholders' equity, the company generated A$0.20 in profit.

See our latest analysis for Cochlear

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. 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.

Cochlear's Earnings Growth And 20% ROE

At first glance, Cochlear seems to have a decent ROE. Further, the company's ROE compares quite favorably to the industry average of 9.9%. Probably as a result of this, Cochlear was able to see an impressive net income growth of 31% over the last five years. We reckon that there could also be other factors at play here. Such as - high earnings retention or an efficient management in place.

As a next step, we compared Cochlear'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 18%.

Earnings growth is an important metric to consider when valuing a stock. 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. If you're wondering about Cochlear's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Cochlear Making Efficient Use Of Its Profits?

Cochlear's significant three-year median payout ratio of 73% (where it is retaining only 27% of its income) suggests that the company has been able to achieve a high growth in earnings despite returning most of its income to shareholders.

Besides, Cochlear has been paying dividends for at least ten years or more. This shows that the company is committed to sharing profits with its shareholders. Based on the latest analysts' estimates, we found that the company's future payout ratio over the next three years is expected to hold steady at 69%. Regardless, the future ROE for Cochlear is predicted to rise to 26% despite there being not much change expected in its payout ratio.

Conclusion

In total, we are pretty happy with Cochlear's performance. We are particularly impressed by the considerable earnings growth posted by the company, which was likely backed by its high ROE. While the company is paying out most of its earnings as dividends, it has been able to grow its earnings in spite of it, so that's probably a good sign. Having said that, the company's earnings growth is expected to slow down, as forecasted in the current analyst estimates. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts 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.