The Eastern Company (NASDAQ:EML) stock has been showing weakness lately, but the financial outlook looks decent: is the market wrong?

Eastern Inc (NASDAQ:EML) had a rough week with its share price down 11%. But if you pay close attention, you might find that its leading financial indicators look pretty decent, which could mean the stock could potentially rise in the long run as markets generally reward more resilient long-term fundamentals. Specifically, we decided to study Eastern’s ROE in this article.

Return on equity or ROE is a key metric used to gauge how effectively a company’s management is using the company’s capital. In other words, it is a profitability ratio that measures the rate of return on capital contributed by the company’s shareholders.

How to calculate return on equity?

the return on equity formula is:

Return on equity = Net income (from continuing operations) ÷ Equity

So, based on the formula above, the ROE for the East is:

8.7% = $9.8 million ÷ $112 million (based on trailing twelve months to October 2021).

The “yield” is the profit of the last twelve months. This therefore means that for every $1 of investment by its shareholder, the company generates a profit of $0.09.

What is the relationship between ROE and earnings growth?

We have already established that ROE serves as an effective profit-generating indicator for a company’s future earnings. Depending on how much of its profits the company chooses to reinvest or “keep”, we are then able to assess a company’s future ability to generate profits. Generally speaking, all things being equal, companies with high return on equity and earnings retention have a higher growth rate than companies that do not share these attributes.

Eastern earnings growth and 8.7% ROE

When you first look at it, Eastern’s ROE doesn’t look that appealing. Yet further investigation shows that the company’s ROE is similar to the industry average of 10%. Even so, Eastern posted a pretty decent growth in net profit, which grew at a rate of 7.5%. Given the slightly weak ROE, it is likely that other factors could be driving this growth. Such as – high revenue retention or effective management in place.

We then performed a comparison between Eastern’s net income growth and that of the industry, which revealed that the company’s growth is similar to the average industry growth of 8.5% over the of the same period.

NasdaqGM: EML Past Earnings Growth January 22, 2022

Earnings growth is an important metric to consider when evaluating a stock. It is important for an investor to know whether the market has priced in the expected growth (or decline) in the company’s earnings. This will help them determine if the future of the title looks bright or ominous. If you’re wondering about Eastern’s rating, check out this gauge of its price/earnings ratio, relative to its industry.

Is Eastern effectively using its retained earnings?

Eastern’s three-year median payout ratio to shareholders is 22% (implying it retains 79% of its revenue), which is lower, so it appears management is heavily reinvesting earnings to grow its activity.

Moreover, Eastern has paid dividends over a period of at least ten years, which means that the company is quite serious about sharing its profits with its shareholders.

Conclusion

Overall, we think Eastern certainly has some positives to consider. Even despite the low rate of return, the company has shown impressive earnings growth thanks to massive reinvestment in its business. While we wouldn’t completely dismiss the business, what we would do is try to figure out how risky the business is to make a more informed decision about the business. To find out about the 3 risks we have identified for the East, visit our risk dashboard for free.

Feedback on this article? Concerned about content? Get in touch with us directly. You can also email the editorial team (at) Simplywallst.com.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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