GR Engineering Services Limited (ASX:GNG) Is Going Strong But Fundamentals Appear To Be Mixed : Is There A Clear Direction For The Stock?

GR Engineering Services (ASX:GNG) has had a great run on the share market with its stock up by a significant 22% over the last three months. However, we decided to pay attention to the company's fundamentals which don't appear to give a clear sign about the company's financial health. Particularly, we will be paying attention to GR Engineering Services' ROE today.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

See our latest analysis for GR Engineering Services

How Is ROE Calculated?

The formula for ROE is:

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

So, based on the above formula, the ROE for GR Engineering Services is:

34% = AU$12m ÷ AU$36m (Based on the trailing twelve months to December 2020).

The 'return' is the amount earned after tax over the last twelve months. One way to conceptualize this is that for each A$1 of shareholders' capital it has, the company made A$0.34 in profit.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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 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.

GR Engineering Services' Earnings Growth And 34% ROE

First thing first, we like that GR Engineering Services has an impressive ROE. Additionally, the company's ROE is higher compared to the industry average of 13% which is quite remarkable. Needless to say, we are quite surprised to see that GR Engineering Services' net income shrunk at a rate of 40% over the past five years. So, there might be some other aspects that could explain this. For example, it could be that the company has a high payout ratio or the business has allocated capital poorly, for instance.

So, as a next step, we compared GR Engineering Services' 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 33% in the same period.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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. Is GR Engineering Services fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is GR Engineering Services Efficiently Re-investing Its Profits?

With a three-year median payout ratio as high as 111%,GR Engineering Services' shrinking earnings don't come as a surprise as the company is paying a dividend which is beyond its means. Paying a dividend higher than reported profits is not a sustainable move.

Moreover, GR Engineering Services 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 77% over the next three years. Despite the lower expected payout ratio, the company's ROE is not expected to change by much.

Summary

On the whole, we feel that the performance shown by GR Engineering Services can be open to many interpretations. While the company does have a high rate of return, its low earnings retention is probably what's hampering its earnings growth. 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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