Does Downer EDI Limited's (ASX:DOW) Weak Fundamentals Mean A Downturn In Its Stock Should Be Expected?

Downer EDI's (ASX:DOW) stock is up by 9.6% over the past three months. However, its weak financial performance indicators makes us a bit doubtful if that trend could continue. In this article, we decided to focus on Downer EDI's ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

View our latest analysis for Downer EDI

How Is ROE Calculated?

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 Downer EDI is:

6.8% = AU$197m ÷ AU$2.9b (Based on the trailing twelve months to December 2021).

The 'return' refers to a company's earnings over the last year. That means that for every A$1 worth of shareholders' equity, the company generated A$0.07 in profit.

Why Is ROE Important For 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 all else is equal, companies that have both a higher return on equity and higher profit retention are usually the ones that have a higher growth rate when compared to companies that don't have the same features.

A Side By Side comparison of Downer EDI's Earnings Growth And 6.8% ROE

At first glance, Downer EDI's ROE doesn't look very promising. Yet, a closer study shows that the company's ROE is similar to the industry average of 7.0%. But Downer EDI saw a five year net income decline of 16% over the past five years. Remember, the company's ROE is a bit low to begin with. Therefore, the decline in earnings could also be the result of this.

However, when we compared Downer EDI's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 4.3% in the same period. This is quite worrisome.

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. If you're wondering about Downer EDI's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Downer EDI Making Efficient Use Of Its Profits?

With a high three-year median payout ratio of 79% (implying that 21% of the profits are retained), most of Downer EDI's profits are being paid to shareholders, which explains the company's shrinking earnings. With only a little being reinvested into the business, earnings growth would obviously be low or non-existent. To know the 2 risks we have identified for Downer EDI visit our risks dashboard for free.

In addition, Downer EDI has been paying dividends over a period of nine years suggesting that keeping up dividend payments is preferred by the management even though earnings have been in decline. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 73%. However, Downer EDI's ROE is predicted to rise to 9.8% despite there being no anticipated change in its payout ratio.

Conclusion

In total, we would have a hard think before deciding on any investment action concerning Downer EDI. Because the company is not reinvesting much into the business, and given the low ROE, it's not surprising to see the lack or absence of growth in its earnings. That being so, the latest industry analyst forecasts show that the analysts are expecting to see a huge improvement in the company's earnings growth rate. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.

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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.