Is Weakness In Incitec Pivot Limited (ASX:IPL) Stock A Sign That The Market Could be Wrong Given Its Strong Financial Prospects?

With its stock down 6.4% over the past month, it is easy to disregard Incitec Pivot (ASX:IPL). However, a closer look at its sound financials might cause you to think again. Given that fundamentals usually drive long-term market outcomes, the company is worth looking at. Specifically, we decided to study Incitec Pivot'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. Put another way, it reveals the company's success at turning shareholder investments into profits.

Check out our latest analysis for Incitec Pivot

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 Incitec Pivot is:

14% = AU$853m ÷ AU$6.3b (Based on the trailing twelve months to March 2023).

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$0.14 in profit.

Why Is ROE Important For Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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.

Incitec Pivot's Earnings Growth And 14% ROE

To start with, Incitec Pivot's ROE looks acceptable. On comparing with the average industry ROE of 6.3% the company's ROE looks pretty remarkable. This probably laid the ground for Incitec Pivot's significant 40% net income growth seen over the past five years. However, there could also be other causes behind this growth. Such as - high earnings retention or an efficient management in place.

As a next step, we compared Incitec Pivot's net income growth with the industry, and pleasingly, we found that the growth seen by the company is higher than the average industry growth of 12%.

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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. 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 Efficiently Re-investing Its Profits?

Incitec Pivot has a significant three-year median payout ratio of 59%, meaning the company only retains 41% of its income. This implies that the company has been able to achieve high earnings growth despite returning most of its profits to shareholders.

Moreover, Incitec Pivot is determined to keep sharing its profits with shareholders which we infer from its long history of paying a dividend for at least ten years. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 52%. However, Incitec Pivot's future ROE is expected to decline to 6.5% despite there being not much change anticipated in the company's payout ratio.

Summary

In total, we are pretty happy with Incitec Pivot's performance. Especially the high ROE, Which has contributed to the impressive growth seen in earnings. Despite the company reinvesting only a small portion of its profits, it still has managed to grow its earnings so that is appreciable. Having said that, on studying current analyst estimates, we were concerned to see that while the company has grown its earnings in the past, analysts expect its earnings to shrink 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.