Most readers would already know that Essentra's (LON:ESNT) stock increased by 7.0% over the past three months. Given that the markets usually pay for the long-term financial health of a company, we wonder if the current momentum in the share price will keep up, given that the company's financials don't look very promising. Particularly, we will be paying attention to Essentra's ROE today.

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 short, ROE shows the profit each dollar generates with respect to its shareholder investments.

Check out our latest analysis for Essentra

How Do You 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 Essentra is:

2.1% = UK￡5.8m ÷ UK￡273m (Based on the trailing twelve months to December 2023).

The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each ￡1 of shareholders' capital it has, the company made ￡0.02 in profit.

Why Is ROE Important For 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. 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.

A Side By Side comparison of Essentra's Earnings Growth And 2.1% ROE

As you can see, Essentra's ROE looks pretty weak. Even when compared to the industry average of 7.6%, the ROE figure is pretty disappointing. Given the circumstances, the significant decline in net income by 65% seen by Essentra over the last five years is not surprising. We reckon that there could also be other factors at play here. Such as - low earnings retention or poor allocation of capital.

Furthermore, even when compared to the industry, which has been shrinking its earnings at a rate of 2.5% over the last few years, we found that Essentra's performance is pretty disappointing, as it suggests that the company has been shrunk its earnings at a rate faster than the industry.

Earnings growth is an important metric to consider when valuing a stock. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. Doing so will help them establish if the stock's future looks promising or ominous. 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 Essentra is trading on a high P/E or a low P/E, relative to its industry.