Could The Market Be Wrong About Drax Group plc (LON:DRX) Given Its Attractive Financial Prospects?

It is hard to get excited after looking at Drax Group's (LON:DRX) recent performance, when its stock has declined 7.3% over the past three months. But if you pay close attention, you might gather that its strong financials could mean that the stock could potentially see an increase in value in the long-term, given how markets usually reward companies with good financial health. In this article, we decided to focus on Drax Group'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. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

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How To Calculate Return On Equity?

ROE 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 Drax Group is:

25% = UK£526m ÷ UK£2.1b (Based on the trailing twelve months to December 2024).

The 'return' is the income the business earned over the last year. So, this means that for every £1 of its shareholder's investments, the company generates a profit of £0.25.

View our latest analysis for Drax Group

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. Depending on how much of these profits the company reinvests or "retains", and how effectively it does so, we are then able to assess a company’s earnings growth potential. 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.

Drax Group's Earnings Growth And 25% ROE

To begin with, Drax Group has a pretty high ROE which is interesting. Second, a comparison with the average ROE reported by the industry of 8.9% also doesn't go unnoticed by us. Under the circumstances, Drax Group's considerable five year net income growth of 66% was to be expected.

Next, on comparing with the industry net income growth, we found that Drax Group's growth is quite high when compared to the industry average growth of 25% in the same period, which is great to see.

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. If you're wondering about Drax Group's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Drax Group Making Efficient Use Of Its Profits?

Drax Group's three-year median payout ratio is a pretty moderate 37%, meaning the company retains 63% of its income. This suggests that its dividend is well covered, and given the high growth we discussed above, it looks like Drax Group is reinvesting its earnings efficiently.

Moreover, Drax Group is determined to keep sharing its profits with shareholders which we infer from its long history of paying a dividend for at least ten years. Looking at the current analyst consensus data, we can see that the company's future payout ratio is expected to rise to 55% over the next three years. Accordingly, the expected increase in the payout ratio explains the expected decline in the company's ROE to 10%, over the same period.

Summary

Overall, we are quite pleased 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. That being so, according to the latest industry analyst forecasts, the company's earnings are expected 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.