The Environmental Group Limited's (ASX:EGL) Stock Is Rallying But Financials Look Ambiguous: Will The Momentum Continue?

By
Simply Wall St
Published
December 21, 2021
ASX:EGL
Source: Shutterstock

Environmental Group's (ASX:EGL) stock is up by a considerable 46% 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. In this article, we decided to focus on Environmental Group's ROE.

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.

Check out our latest analysis for Environmental Group

How To 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 Environmental Group is:

9.5% = AU$1.7m ÷ AU$18m (Based on the trailing twelve months to June 2021).

The 'return' is the amount earned after tax over the last twelve months. That means that for every A$1 worth of shareholders' equity, the company generated A$0.10 in profit.

What Is The Relationship Between ROE And Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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 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 Environmental Group's Earnings Growth And 9.5% ROE

On the face of it, Environmental Group's ROE is not much to talk about. Next, when compared to the average industry ROE of 13%, the company's ROE leaves us feeling even less enthusiastic. Given the circumstances, the significant decline in net income by 24% seen by Environmental Group over the last five years is not surprising. We reckon that there could also be other factors at play here. For instance, the company has a very high payout ratio, or is faced with competitive pressures.

So, as a next step, we compared Environmental Group'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 26% in the same period.

past-earnings-growth
ASX:EGL Past Earnings Growth December 21st 2021

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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 Environmental Group is trading on a high P/E or a low P/E, relative to its industry.

Is Environmental Group Making Efficient Use Of Its Profits?

While the company did payout a portion of its dividend in the past, it currently doesn't pay a dividend. This implies that potentially all of its profits are being reinvested in the business.

Summary

On the whole, we feel that the performance shown by Environmental Group can be open to many interpretations. While the company does have a high rate of profit retention, its low rate of return is probably hampering its earnings growth. Wrapping up, we would proceed with caution with this company and one way of doing that would be to look at the risk profile of the business. Our risks dashboard would have the 5 risks we have identified for Environmental Group.

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