Are Waterco Limited's (ASX:WAT) Fundamentals Good Enough to Warrant Buying Given The Stock's Recent Weakness?

It is hard to get excited after looking at Waterco's (ASX:WAT) recent performance, when its stock has declined 2.4% over the past month. 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 Waterco's 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.

Check out our latest analysis for Waterco

How Is ROE Calculated?

Return on equity 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 Waterco is:

3.5% = AU$3.0m ÷ AU$87m (Based on the trailing twelve months to June 2020).

The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each A$1 of shareholders' capital it has, the company made A$0.03 in profit.

What Has ROE Got To Do With 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.

Waterco's Earnings Growth And 3.5% ROE

It is hard to argue that Waterco's ROE is much good in and of itself. Not just that, even compared to the industry average of 9.7%, the company's ROE is entirely unremarkable. Although, we can see that Waterco saw a modest net income growth of 7.0% over the past five years. We believe that there might be other aspects that are positively influencing the company's earnings growth. For instance, the company has a low payout ratio or is being managed efficiently.

Next, on comparing Waterco's net income growth with the industry, we found that the company's reported growth is similar to the industry average growth rate of 7.4% in the same period.

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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is Waterco fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Waterco Using Its Retained Earnings Effectively?

The high three-year median payout ratio of 56% (or a retention ratio of 44%) for Waterco suggests that the company's growth wasn't really hampered despite it returning most of its income to its shareholders.

Additionally, Waterco has paid dividends over a period of at least ten years which means that the company is pretty serious about sharing its profits with shareholders.

Summary

On the whole, we do feel that Waterco has some positive attributes. While no doubt its earnings growth is pretty substantial, we do feel that the reinvestment rate is pretty low, meaning, the earnings growth number could have been significantly higher had the company been retaining more of its profits. So far, we've only made a quick discussion around the company's earnings growth. You can do your own research on Waterco and see how it has performed in the past by looking at this FREE detailed graph of past earnings, revenue and cash flows.

If you’re looking to trade Waterco, open an account with the lowest-cost* platform trusted by professionals, Interactive Brokers. Their clients from over 200 countries and territories trade stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted

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.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.