Can Mixed Fundamentals Have A Negative Impact on Orica Limited (ASX:ORI) Current Share Price Momentum?

Orica (ASX:ORI) has had a great run on the share market with its stock up by a significant 11% 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 Orica'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.

See our latest analysis for Orica

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 Orica is:

6.2% = AU$251m ÷ AU$4.1b (Based on the trailing twelve months to September 2023).

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$0.06 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. 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.

Orica's Earnings Growth And 6.2% ROE

At first glance, Orica's ROE doesn't look very promising. Although a closer study shows that the company's ROE is higher than the industry average of 4.3% which we definitely can't overlook. Still, Orica has seen a flat net income growth over the past five years. Remember, the company's ROE is a bit low to begin with, just that it is higher than the industry average. Therefore, the low to flat growth in earnings could also be the result of this.

Next, on comparing with the industry net income growth, we found that the industry grew its earnings by 6.6% over the last few years.

Earnings growth is a huge factor in stock valuation. 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. Has the market priced in the future outlook for ORI? You can find out in our latest intrinsic value infographic research report.

Is Orica Making Efficient Use Of Its Profits?

With a high three-year median payout ratio of 66% (implying that the company keeps only 34% of its income) of its business to reinvest into its business), most of Orica's profits are being paid to shareholders, which explains the absence of growth in earnings.

In addition, Orica 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's future payout ratio is expected to drop to 52% over the next three years. The fact that the company's ROE is expected to rise to 12% over the same period is explained by the drop in the payout ratio.

Conclusion

On the whole, we feel that the performance shown by Orica can be open to many interpretations. On the one hand, the company does have a decent rate of return, however, its earnings growth number is quite disappointing and as discussed earlier, the low retained earnings is hampering the growth. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. 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. 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.