With its stock down 32% over the past month, it is easy to disregard Phoslock Environmental Technologies (ASX:PET). However, stock prices are usually driven by a company’s financials over the long term, which in this case look pretty respectable. Specifically, we decided to study Phoslock Environmental Technologies' ROE in this article.
Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
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 Phoslock Environmental Technologies is:
9.0% = AU$2.7m ÷ AU$30m (Based on the trailing twelve months to December 2019).
The 'return' is the yearly profit. Another way to think of that is that for every A$1 worth of equity, the company was able to earn A$0.09 in profit.
What Has ROE Got To Do With Earnings Growth?
Thus far, we have learnt that ROE measures how efficiently a company is generating its profits. 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.
Phoslock Environmental Technologies' Earnings Growth And 9.0% ROE
At first glance, Phoslock Environmental Technologies' ROE doesn't look very promising. However, given that the company's ROE is similar to the average industry ROE of 9.0%, we may spare it some thought. Moreover, we are quite pleased to see that Phoslock Environmental Technologies' net income grew significantly at a rate of 38% over the last five years. Given the slightly low ROE, it is likely that there could be some other aspects that are driving this growth. For example, it is possible that the company's management has made some good strategic decisions, or that the company has a low payout ratio.
We then compared Phoslock Environmental Technologies' net income growth with the industry and we're pleased to see that the company's growth figure is higher when compared with the industry which has a growth rate of 23% in the same period.
Earnings growth is a huge factor in stock valuation. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. 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 Phoslock Environmental Technologies is trading on a high P/E or a low P/E, relative to its industry.
Is Phoslock Environmental Technologies Efficiently Re-investing Its Profits?
Phoslock Environmental Technologies doesn't pay any dividend currently which essentially means that it has been reinvesting all of its profits into the business. This definitely contributes to the high earnings growth number that we discussed above.
On the whole, we do feel that Phoslock Environmental Technologies has some positive attributes. Despite its low rate of return, the fact that the company reinvests a very high portion of its profits into its business, no doubt contributed to its high earnings growth. While we won't completely dismiss the company, what we would do, is try to ascertain how risky the business is to make a more informed decision around the company. You can see the 2 risks we have identified for Phoslock Environmental Technologies by visiting our risks dashboard for free on our platform here.
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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. Thank you for reading.
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