Are Strong Financial Prospects The Force That Is Driving The Momentum In Drax Group plc's LON:DRX) Stock?

Most readers would already be aware that Drax Group's (LON:DRX) stock increased significantly by 23% over the past three months. Given that the market rewards strong financials in the long-term, we wonder if that is the case in this instance. Specifically, we decided to study Drax Group's ROE in this article.

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. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

View our latest analysis for Drax Group

How Is ROE Calculated?

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 Drax Group is:

11% = UK£182m ÷ UK£1.6b (Based on the trailing twelve months to June 2023).

The 'return' is the profit over the last twelve months. So, this means that for every £1 of its shareholder's investments, the company generates a profit of £0.11.

What Has ROE Got To Do With Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. 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.

Drax Group's Earnings Growth And 11% ROE

To begin with, Drax Group seems to have a respectable ROE. Further, the company's ROE is similar to the industry average of 10%. Consequently, this likely laid the ground for the impressive net income growth of 42% seen over the past five years by Drax Group. We reckon that there could also be other factors at play here. For instance, the company has a low payout ratio or is being managed efficiently.

As a next step, we compared Drax Group's net income growth with the industry, and pleasingly, we found that the growth seen by the company is higher than the average industry growth of 29%.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). Doing so will help them establish if the stock's future looks promising or ominous. Is DRX fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is Drax Group Making Efficient Use Of Its Profits?

Drax Group has a three-year median payout ratio of 42% (where it is retaining 58% of its income) which is not too low or not too high. By the looks of it, the dividend is well covered and Drax Group is reinvesting its profits efficiently as evidenced by its exceptional growth which we discussed above.

Besides, Drax Group has been paying dividends for at least ten years or more. This shows that the company is committed to sharing profits with its shareholders. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 26% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 27%, over the same period.

Summary

In total, we are pretty happy with Drax Group's performance. Particularly, we like that the company is reinvesting heavily into its business, and at a high rate of return. Unsurprisingly, this has led to an impressive earnings growth. Having said that, the company's earnings growth is expected to slow down, as forecasted in the current analyst estimates. 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.