Is The Market Rewarding Divgi TorqTransfer Systems Limited (NSE:DIVGIITTS) With A Negative Sentiment As A Result Of Its Mixed Fundamentals?

With its stock down 19% over the past three months, it is easy to disregard Divgi TorqTransfer Systems (NSE:DIVGIITTS). It is possible that the markets have ignored the company's differing financials and decided to lean-in to the negative sentiment. Stock prices are usually driven by a company’s financial performance over the long term, and therefore we decided to pay more attention to the company's financial performance. In this article, we decided to focus on Divgi TorqTransfer Systems' ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

See our latest analysis for Divgi TorqTransfer Systems

How To 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 Divgi TorqTransfer Systems is:

5.5% = ₹324m ÷ ₹5.9b (Based on the trailing twelve months to September 2024).

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 ₹0.06 in profit.

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. 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. 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.

Divgi TorqTransfer Systems' Earnings Growth And 5.5% ROE

It is hard to argue that Divgi TorqTransfer Systems' ROE is much good in and of itself. Not just that, even compared to the industry average of 12%, the company's ROE is entirely unremarkable. Thus, the low net income growth of 3.2% seen by Divgi TorqTransfer Systems over the past five years could probably be the result of it having a lower ROE.

We then compared Divgi TorqTransfer Systems' net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 28% in the same 5-year period, which is a bit concerning.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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. One good indicator of expected earnings growth is the P/E ratio which determines the price the market is willing to pay for a stock based on its earnings prospects. So, you may want to check if Divgi TorqTransfer Systems is trading on a high P/E or a low P/E, relative to its industry.

Is Divgi TorqTransfer Systems Efficiently Re-investing Its Profits?

A low three-year median payout ratio of 20% (implying that the company retains the remaining 80% of its income) suggests that Divgi TorqTransfer Systems is retaining most of its profits. This should be reflected in its earnings growth number, but that's not the case. So there could be some other explanation in that regard. For instance, the company's business may be deteriorating.

Additionally, Divgi TorqTransfer Systems started paying a dividend only recently. So it looks like the management must have perceived that shareholders favor dividends over earnings growth. Based on the latest analysts' estimates, we found that the company's future payout ratio over the next three years is expected to hold steady at 21%. Regardless, the future ROE for Divgi TorqTransfer Systems is predicted to rise to 8.7% despite there being not much change expected in its payout ratio.

Conclusion

Overall, we have mixed feelings about Divgi TorqTransfer Systems. Even though it appears to be retaining most of its profits, given the low ROE, investors may not be benefitting from all that reinvestment after all. The low earnings growth suggests our theory correct. Having said that, looking at the current analyst estimates, we found that the company's earnings are expected to gain momentum. 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. 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.