Most readers would already know that Cochlear's (ASX:COH) stock increased by 1.5% over the past month. Given that the market rewards strong financials in the long-term, we wonder if that is the case in this instance. In this article, we decided to focus on Cochlear's ROE.

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. Put another way, it reveals the company's success at turning shareholder investments into profits.

View our latest analysis for Cochlear

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$350m ÷ AU$1.8b (Based on the trailing twelve months to December 2023).

The 'return' is the profit over the last twelve months. Another way to think of that is that for every A$1 worth of equity, the company was able to earn A$0.20 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. 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.

Cochlear's Earnings Growth And 20% ROE

To begin with, Cochlear seems to have a respectable ROE. Especially when compared to the industry average of 7.7% the company's ROE looks pretty impressive. This probably laid the ground for Cochlear's moderate 14% net income growth seen over the past five years.

We then compared Cochlear's net income growth with the industry and we're pleased to see that the company's growth figure is higher when compared with the industry which has a growth rate of 5.6% in the same 5-year period.

Earnings growth is a huge factor in stock valuation. 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 Cochlear is trading on a high P/E or a low P/E, relative to its industry.