Most readers would already know that Incitec Pivot's (ASX:IPL) stock increased by 8.4% over the past three months. However, we decided to study the company's mixed-bag of fundamentals to assess what this could mean for future share prices, as stock prices tend to be aligned with a company's long-term financial performance. Particularly, we will be paying attention to Incitec Pivot's ROE today.
ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. Put another way, it reveals the company's success at turning shareholder investments into profits.
How Do You Calculate Return On Equity?
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 Incitec Pivot is:
2.8% = AU$149m ÷ AU$5.4b (Based on the trailing twelve months to September 2021).
The 'return' is the amount earned after tax over the last twelve months. That means that for every A$1 worth of shareholders' equity, the company generated A$0.03 in profit.
Why Is ROE Important For Earnings Growth?
We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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. 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.
A Side By Side comparison of Incitec Pivot's Earnings Growth And 2.8% ROE
It is hard to argue that Incitec Pivot's ROE is much good in and of itself. Not just that, even compared to the industry average of 9.6%, the company's ROE is entirely unremarkable. For this reason, Incitec Pivot's five year net income decline of 13% is not surprising given its lower ROE. We believe that there also might be other aspects that are negatively influencing the company's earnings prospects. For instance, the company has a very high payout ratio, or is faced with competitive pressures.
However, when we compared Incitec Pivot's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 23% in the same period. This is quite worrisome.
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. This then helps them determine if the stock is placed for a bright or bleak future. What is IPL worth today? The intrinsic value infographic in our free research report helps visualize whether IPL is currently mispriced by the market.
Is Incitec Pivot Using Its Retained Earnings Effectively?
Looking at its three-year median payout ratio of 50% (or a retention ratio of 50%) which is pretty normal, Incitec Pivot's declining earnings is rather baffling as one would expect to see a fair bit of growth when a company is retaining a good portion of its profits. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.
Moreover, Incitec Pivot 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. Based on the latest analysts' estimates, we found that the company's future payout ratio over the next three years is expected to hold steady at 48%. Regardless, the future ROE for Incitec Pivot is predicted to rise to 7.1% despite there being not much change expected in its payout ratio.
Overall, we have mixed feelings about Incitec Pivot. Even though it appears to be retaining most of its profits, given the low ROE, investors may not be benefitting from all that reinvestment after all. The low earnings growth suggests our theory correct. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. 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.