Is Direcional Engenharia S.A.'s (BVMF:DIRR3) Stock On A Downtrend As A Result Of Its Poor Financials?

It is hard to get excited after looking at Direcional Engenharia's (BVMF:DIRR3) recent performance, when its stock has declined 14% over the past month. We decided to study the company's financials to determine if the downtrend will continue as the long-term performance of a company usually dictates market outcomes. Specifically, we decided to study Direcional Engenharia's ROE in this article.

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 other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

View our latest analysis for Direcional Engenharia

How Do You Calculate Return On Equity?

The formula for ROE is:

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

So, based on the above formula, the ROE for Direcional Engenharia is:

8.9% = R$129m ÷ R$1.5b (Based on the trailing twelve months to September 2020).

The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each R$1 of shareholders' capital it has, the company made R$0.09 in profit.

What Has ROE Got To Do With 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.

Direcional Engenharia's Earnings Growth And 8.9% ROE

As you can see, Direcional Engenharia's ROE looks pretty weak. Not just that, even compared to the industry average of 14%, the company's ROE is entirely unremarkable. For this reason, Direcional Engenharia's five year net income decline of 4.4% is not surprising given its lower ROE. However, there could also be other factors causing the earnings to decline. For instance, the company has a very high payout ratio, or is faced with competitive pressures.

That being said, we compared Direcional Engenharia's performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 11% in the same period.

Earnings growth is a huge factor in stock valuation. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is DIRR3 fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is Direcional Engenharia Making Efficient Use Of Its Profits?

Direcional Engenharia's high LTM (or last twelve month) payout ratio of 120% suggests that the company is depleting its resources to keep up its dividend payments, and this shows in its shrinking earnings. Paying a dividend beyond their means is usually not viable over the long term. Our risks dashboard should have the 2 risks we have identified for Direcional Engenharia.

Moreover, Direcional Engenharia 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 68% over the next three years. As a result, the expected drop in Direcional Engenharia's payout ratio explains the anticipated rise in the company's future ROE to 19%, over the same period.

Summary

In total, we would have a hard think before deciding on any investment action concerning Direcional Engenharia. Particularly, its ROE is a huge disappointment, not to mention its lack of proper reinvestment into the business. As a result its earnings growth has also been quite disappointing. 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. 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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