Downer EDI Limited's (ASX:DOW) Dismal Stock Performance Reflects Weak Fundamentals

With its stock down 6.8% over the past month, it is easy to disregard Downer EDI (ASX:DOW). To decide if this trend could continue, we decided to look at its weak fundamentals as they shape the long-term market trends. Specifically, we decided to study Downer EDI'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.

View our latest analysis for Downer EDI

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 Downer EDI is:

3.8% = AU$86m ÷ AU$2.2b (Based on the trailing twelve months to December 2024).

The 'return' refers to a company's earnings over the last year. Another way to think of that is that for every A$1 worth of equity, the company was able to earn A$0.04 in profit.

Why Is ROE Important For Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. 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.

Downer EDI's Earnings Growth And 3.8% ROE

It is quite clear that Downer EDI's ROE is rather low. Not just that, even compared to the industry average of 13%, the company's ROE is entirely unremarkable. For this reason, Downer EDI's five year net income decline of 20% is not surprising given its lower ROE. We believe that there also might be other aspects that are negatively influencing the company's earnings prospects. For example, the business has allocated capital poorly, or that the company has a very high payout ratio.

So, as a next step, we compared Downer EDI'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 15% over the last few years.

Earnings growth is an important metric to consider when valuing a stock. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. This then helps them determine if the stock is placed for a bright or bleak future. What is DOW worth today? The intrinsic value infographic in our free research report helps visualize whether DOW is currently mispriced by the market.

Is Downer EDI Using Its Retained Earnings Effectively?

Downer EDI's declining earnings is not surprising given how the company is spending most of its profits in paying dividends, judging by its three-year median payout ratio of 100% (or a retention ratio of -0.2%). 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 Downer EDI.

Moreover, Downer EDI 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. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 62% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 15%, over the same period.

Conclusion

Overall, we would be extremely cautious before making any decision on Downer EDI. Particularly, its ROE is a huge disappointment, not to mention its lack of proper reinvestment into the business. As a result its earnings growth has also been quite disappointing. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. 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.