Are Continental Aktiengesellschaft's (ETR:CON) Mixed Financials Driving The Negative Sentiment?

Continental (ETR:CON) has had a rough three months with its share price down 3.0%. It seems that the market might have completely ignored the positive aspects of the company's fundamentals and decided to weigh-in more on the negative aspects. Fundamentals usually dictate market outcomes so it makes sense to study the company's financials. In this article, we decided to focus on Continental's ROE.

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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

Check out our latest analysis for Continental

How Do You Calculate Return On Equity?

The formula for return on equity is:

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

So, based on the above formula, the ROE for Continental is:

5.2% = €719m ÷ €14b (Based on the trailing twelve months to June 2023).

The 'return' is the yearly profit. That means that for every €1 worth of shareholders' equity, the company generated €0.05 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. 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.

A Side By Side comparison of Continental's Earnings Growth And 5.2% ROE

When you first look at it, Continental's ROE doesn't look that attractive. We then compared the company's ROE to the broader industry and were disappointed to see that the ROE is lower than the industry average of 15%. For this reason, Continental's five year net income decline of 29% is not surprising given its lower ROE. We reckon that there could also be other factors at play here. Such as - low earnings retention or poor allocation of capital.

So, as a next step, we compared Continental's performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 0.9% over the last few years.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. This then helps them determine if the stock is placed for a bright or bleak future. Is Continental fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Continental Making Efficient Use Of Its Profits?

Looking at its three-year median payout ratio of 41% (or a retention ratio of 59%) which is pretty normal, Continental'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.

In addition, Continental 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. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 28% over the next three years. As a result, the expected drop in Continental's payout ratio explains the anticipated rise in the company's future ROE to 16%, over the same period.

Conclusion

In total, we're a bit ambivalent about Continental's performance. While the company does have a high rate of profit retention, its low rate of return is probably hampering its earnings growth. 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 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.