Pembina Pipeline's (TSE:PPL) stock is up by a considerable 15% over the past three months. However, we decided to pay attention to the company's fundamentals which don't appear to give a clear sign about the company's financial health. Specifically, we decided to study Pembina Pipeline's ROE in this article.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Put another way, it reveals the company's success at turning shareholder investments into profits.
How Do You Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Pembina Pipeline is:
9.7% = CA$1.4b ÷ CA$15b (Based on the trailing twelve months to March 2022).
The 'return' is the profit over the last twelve months. That means that for every CA$1 worth of shareholders' equity, the company generated CA$0.10 in profit.
What Has ROE Got To Do With 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. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don’t share these attributes.
A Side By Side comparison of Pembina Pipeline's Earnings Growth And 9.7% ROE
To begin with, Pembina Pipeline seems to have a respectable ROE. Even so, when compared with the average industry ROE of 22%, we aren't very excited. Moreover, Pembina Pipeline's net income shrunk at a rate of 11%over the past five years. Not to forget, the company does have a high ROE to begin with, just that it is lower than the industry average. So there might be other reasons for the earnings to shrink. These include low earnings retention or poor allocation of capital.
So, as a next step, we compared Pembina Pipeline's performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 14% in the same 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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Has the market priced in the future outlook for PPL? You can find out in our latest intrinsic value infographic research report.
Is Pembina Pipeline Using Its Retained Earnings Effectively?
Pembina Pipeline has a high three-year median payout ratio of 88% (that is, it is retaining 12% of its profits). This suggests that the company is paying most of its profits as dividends to its shareholders. This goes some way in explaining why its earnings have been shrinking. With only very little left to reinvest into the business, growth in earnings is far from likely. Our risks dashboard should have the 2 risks we have identified for Pembina Pipeline.
Moreover, Pembina Pipeline has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over earnings growth. 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 98%. Regardless, the future ROE for Pembina Pipeline is predicted to rise to 12% despite there being not much change expected in its payout ratio.
In total, we're a bit ambivalent about Pembina Pipeline's performance. On the one hand, the company does have a decent rate of return, however, its earnings growth number is quite disappointing and as discussed earlier, the low retained earnings is hampering the growth. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page 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.