Covestro's (ETR:1COV) stock is up by a considerable 5.8% over the past month. We wonder if and what role the company's financials play in that price change as a company's long-term fundamentals usually dictate market outcomes. Specifically, we decided to study Covestro'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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.
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 Covestro is:
22% = €1.6b ÷ €7.3b (Based on the trailing twelve months to September 2021).
The 'return' is the amount earned after tax over the last twelve months. That means that for every €1 worth of shareholders' equity, the company generated €0.22 in profit.
Why Is ROE Important For 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. 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.
Covestro's Earnings Growth And 22% ROE
To begin with, Covestro has a pretty high ROE which is interesting. Second, a comparison with the average ROE reported by the industry of 15% also doesn't go unnoticed by us. As you might expect, the 12% net income decline reported by Covestro doesn't bode well with us. We reckon that there could be some other factors at play here that are preventing the company's growth. Such as, the company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.
Furthermore, even when compared to the industry, which has been shrinking its earnings at a rate 3.7% in the same period, we found that Covestro's performance is pretty disappointing, as it suggests that the company has been shrunk its earnings at a rate faster than the industry.
Earnings growth is an important metric to consider when valuing a stock. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. Doing so will help them establish if the stock's future looks promising or ominous. Is Covestro fairly valued compared to other companies? These 3 valuation measures might help you decide.
Is Covestro Using Its Retained Earnings Effectively?
Looking at its three-year median payout ratio of 40% (or a retention ratio of 60%) which is pretty normal, Covestro'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 could be some other explanations in that regard. For instance, the company's business may be deteriorating.
Additionally, Covestro has paid dividends over a period of six years, which means that the company's management is rather focused on keeping up its dividend payments, regardless of the shrinking earnings. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to rise to 59% over the next three years. Accordingly, the expected increase in the payout ratio explains the expected decline in the company's ROE to 13%, over the same period.
Overall, we feel that Covestro certainly does have some positive factors to consider. Yet, the low earnings growth is a bit concerning, especially given that the company has a high rate of return and is reinvesting ma huge portion of its profits. By the looks of it, there could be some other factors, not necessarily in control of the business, that's preventing growth. Moreover, after studying current analyst estimates, we discovered that the company's earnings are expected to continue to shrink 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. 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.