Diploma (LON:DPLM) has had a great run on the share market with its stock up by a significant 20% over the last three months. Given that the market rewards strong financials in the long-term, we wonder if that is the case in this instance. Specifically, we decided to study Diploma's ROE in this article.

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. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

Check out our latest analysis for Diploma

How Do You Calculate Return On Equity?

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 Diploma is:

13% = UK￡117m ÷ UK￡881m (Based on the trailing twelve months to March 2024).

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 ￡0.13 in profit.

What Has ROE Got To Do With Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. Depending on how much of these profits the company reinvests or "retains", and how effectively it does so, we are then able to assess a company’s earnings growth potential. 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 Diploma's Earnings Growth And 13% ROE

To start with, Diploma's ROE looks acceptable. And on comparing with the industry, we found that the the average industry ROE is similar at 13%. This certainly adds some context to Diploma's moderate 19% net income growth seen over the past five years.

Next, on comparing with the industry net income growth, we found that Diploma's growth is quite high when compared to the industry average growth of 15% in the same period, which is great to see.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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 Diploma's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.