Pental Limited's (ASX:PTL) Dismal Stock Performance Reflects Weak Fundamentals

With its stock down 5.4% over the past three months, it is easy to disregard Pental (ASX:PTL). 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. Particularly, we will be paying attention to Pental's ROE today.

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.

Check out our latest analysis for Pental

How Do You Calculate Return On Equity?

The formula for ROE is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Pental is:

9.0% = AU$5.0m ÷ AU$56m (Based on the trailing twelve months to June 2020).

The 'return' is the profit over the last twelve months. 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?

So far, we've learned that ROE is a measure of a company's profitability. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. 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.

Pental's Earnings Growth And 9.0% ROE

On the face of it, Pental's ROE is not much to talk about. A quick further study shows that the company's ROE doesn't compare favorably to the industry average of 14% either. Therefore, it might not be wrong to say that the five year net income decline of 30% seen by Pental was probably the result of it having a lower ROE. We believe that there also might be other aspects that are negatively influencing the company's earnings prospects. Such as - low earnings retention or poor allocation of capital.

That being said, we compared Pental's performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 10% in the same period.

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. 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 Pental's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Pental Using Its Retained Earnings Effectively?

Pental'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 76% (or a retention ratio of 24%). With only a little being reinvested into the business, earnings growth would obviously be low or non-existent. Our risks dashboard should have the 2 risks we have identified for Pental.

In addition, Pental has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 67% of its profits over the next three years. However, Pental's ROE is predicted to rise to 14% despite there being no anticipated change in its payout ratio.

Summary

On the whole, Pental's performance is quite a big let-down. 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. 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. 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.
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