Does GEA Group Aktiengesellschaft's (ETR:G1A) Weak Fundamentals Mean That The Market Could Correct Its Share Price?

GEA Group (ETR:G1A) has had a great run on the share market with its stock up by a significant 11% over the last three months. However, in this article, we decided to focus on its weak fundamentals, as long-term financial performance of a business is what ultimatley dictates market outcomes. In this article, we decided to focus on GEA Group's ROE.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

See our latest analysis for GEA Group

How To Calculate Return On Equity?

Return on equity 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 GEA Group is:

5.6% = €108m ÷ €1.9b (Based on the trailing twelve months to December 2020).

The 'return' is the profit over the last twelve months. That means that for every €1 worth of shareholders' equity, the company generated €0.06 in profit.

What Is The Relationship Between ROE And 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. 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.

GEA Group's Earnings Growth And 5.6% ROE

On the face of it, GEA Group's ROE is not much to talk about. Yet, a closer study shows that the company's ROE is similar to the industry average of 5.8%. Having said that, GEA Group's five year net income decline rate was 46%. Remember, the company's ROE is a bit low to begin with. Hence, this goes some way in explaining the shrinking earnings.

However, when we compared GEA Group's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 2.9% 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. This then helps them determine if the stock is placed for a bright or bleak future. What is G1A worth today? The intrinsic value infographic in our free research report helps visualize whether G1A is currently mispriced by the market.

Is GEA Group Making Efficient Use Of Its Profits?

GEA Group has a high three-year median payout ratio of 78% (that is, it is retaining 22% 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. The business is only left with a small pool of capital to reinvest - A vicious cycle that doesn't benefit the company in the long-run.

In addition, GEA Group 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 51% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 15%, over the same period.

Conclusion

In total, we would have a hard think before deciding on any investment action concerning GEA Group. Because the company is not reinvesting much into the business, and given the low ROE, it's not surprising to see the lack or absence of growth in its earnings. 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. 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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