AGL Energy Limited's (ASX:AGL) Has Been On A Rise But Financial Prospects Look Weak: Is The Stock Overpriced?

AGL Energy (ASX:AGL) has had a great run on the share market with its stock up by a significant 13% over the last three months. We, however wanted to have a closer look at its key financial indicators as the markets usually pay for long-term fundamentals, and in this case, they don't look very promising. Particularly, we will be paying attention to AGL Energy'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. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

See our latest analysis for AGL Energy

How To 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 AGL Energy is:

6.9% = AU$378m ÷ AU$5.5b (Based on the trailing twelve months to December 2023).

The 'return' is the yearly profit. That means that for every A$1 worth of shareholders' equity, the company generated A$0.07 in profit.

What Is The Relationship Between ROE And 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.

AGL Energy's Earnings Growth And 6.9% ROE

On the face of it, AGL Energy's ROE is not much to talk about. Next, when compared to the average industry ROE of 10.0%, the company's ROE leaves us feeling even less enthusiastic. Given the circumstances, the significant decline in net income by 33% seen by AGL Energy over the last five years is not surprising. However, there could also be other factors causing the earnings to decline. Such as - low earnings retention or poor allocation of capital.

However, when we compared AGL Energy's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 8.1% in the same period. This is quite worrisome.

Earnings growth is an important metric to consider when valuing a stock. 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. Has the market priced in the future outlook for AGL? You can find out in our latest intrinsic value infographic research report.

Is AGL Energy Making Efficient Use Of Its Profits?

AGL Energy has a high LTM (or last twelve month) payout ratio of 85% (that is, it is retaining 15% of its profits). This suggests that the company is paying most of its profits as dividends to its shareholders. This goes some way in explaining why its earnings have been shrinking. 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 AGL Energy.

Moreover, AGL Energy 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. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 61% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 11%, over the same period.

Summary

Overall, we would be extremely cautious before making any decision on AGL Energy. As a result of its low ROE and lack of much reinvestment into the business, the company has seen a disappointing earnings growth rate. 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. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.

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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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com