Waterco's (ASX:WAT) stock is up by a considerable 22% over the past three months. Given that stock prices are usually aligned with a company's financial performance in the long-term, we decided to study its financial indicators more closely to see if they had a hand to play in the recent price move. In this article, we decided to focus on Waterco's ROE.
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
How To 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 Waterco is:
3.9% = AU$3.1m ÷ AU$78m (Based on the trailing twelve months to December 2019).
The 'return' is the profit over the last twelve months. So, this means that for every A$1 of its shareholder's investments, the company generates a profit of A$0.04.
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. 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 Waterco's Earnings Growth And 3.9% ROE
It is quite clear that Waterco's ROE is rather low. Even compared to the average industry ROE of 8.9%, the company's ROE is quite dismal. Although, we can see that Waterco saw a modest net income growth of 14% over the past five years. Therefore, the growth in earnings could probably have been caused by other variables. For instance, the company has a low payout ratio or is being managed efficiently.
Next, on comparing with the industry net income growth, we found that Waterco's growth is quite high when compared to the industry average growth of 11% in the same period, which is great to see.
Earnings growth is an important metric to consider when valuing a stock. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). Doing so will help them establish if the stock's future looks promising or ominous. If you're wondering about Waterco's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.
Is Waterco Making Efficient Use Of Its Profits?
While Waterco has a three-year median payout ratio of 56% (which means it retains 44% of profits), the company has still seen a fair bit of earnings growth in the past, meaning that its high payout ratio hasn't hampered its ability to grow.
Additionally, Waterco has paid dividends over a period of at least ten years which means that the company is pretty serious about sharing its profits with shareholders.
In total, it does look like Waterco has some positive aspects to its business. That is, quite an impressive growth in earnings. However, the low profit retention means that the company's earnings growth could have been higher, had it been reinvesting a higher portion of its profits. Until now, we have only just grazed the surface of the company's past performance by looking at the company's fundamentals. To gain further insights into Waterco's past profit growth, check out this visualization of past earnings, revenue and cash flows.
This article by Simply Wall St is general in nature. 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.
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