Weak Financial Prospects Seem To Be Dragging Down Downer EDI Limited (ASX:DOW) Stock

With its stock down 14% over the past three months, it is easy to disregard Downer EDI (ASX:DOW). Given that stock prices are usually driven by a company’s fundamentals over the long term, which in this case look pretty weak, we decided to study the company's key financial indicators. 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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

Check out our latest analysis for Downer EDI

How Is ROE Calculated?

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:

4.8% = AU$134m ÷ AU$2.8b (Based on the trailing twelve months to December 2022).

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$0.05.

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. 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.

Downer EDI's Earnings Growth And 4.8% ROE

When you first look at it, Downer EDI's ROE doesn't look that attractive. Yet, a closer study shows that the company's ROE is similar to the industry average of 4.8%. Still, Downer EDI has seen a flat net income growth over the past five years. Remember, the company's ROE is not particularly great to begin with. So that could also be one of the reasons behind the company's flat growth in earnings.

Furthermore, even when compared to the industry, which has been shrinking its earnings at a rate 1.2% in the same period, we found that Downer EDI's performance is pretty disappointing, as it suggests that the company has been shrunk its earnings at a rate faster than the industry.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. 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 Efficiently Re-investing Its Profits?

Downer EDI has a high three-year median payout ratio of 89% (or a retention ratio of 11%), meaning that the company is paying most of its profits as dividends to its shareholders. This does go some way in explaining why there's been no growth in its earnings.

Additionally, Downer EDI has paid dividends over a period of at least ten years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 68% over the next three years. The fact that the company's ROE is expected to rise to 9.9% over the same period is explained by the drop in the payout ratio.

Conclusion

Overall, we would be extremely cautious before making any decision on Downer EDI. The company has seen a lack of earnings growth as a result of retaining very little profits and whatever little it does retain, is being reinvested at a very low rate of return. 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 latest analysts predictions for the company, check out this visualization of analyst forecasts 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.