Can Mixed Fundamentals Have A Negative Impact on Thermax Limited (NSE:THERMAX) Current Share Price Momentum?

Thermax (NSE:THERMAX) has had a great run on the share market with its stock up by a significant 28% over the last three months. However, we wonder if the company's inconsistent financials would have any adverse impact on the current share price momentum. In this article, we decided to focus on Thermax's ROE.

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.

View our latest analysis for Thermax

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 Thermax is:

4.6% = ₹1.4b ÷ ₹31b (Based on the trailing twelve months to September 2020).

The 'return' is the amount earned after tax over the last twelve months. Another way to think of that is that for every ₹1 worth of equity, the company was able to earn ₹0.05 in profit.

What Has ROE Got To Do With Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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. Assuming everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.

A Side By Side comparison of Thermax's Earnings Growth And 4.6% ROE

It is hard to argue that Thermax's ROE is much good in and of itself. Even compared to the average industry ROE of 8.2%, the company's ROE is quite dismal. For this reason, Thermax's five year net income decline of 4.0% is not surprising given its lower ROE. We believe that there also might be other aspects that are negatively influencing the company's earnings prospects. For instance, the company has a very high payout ratio, or is faced with competitive pressures.

That being said, we compared Thermax's performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 7.5% in the same period.

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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is Thermax fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Thermax Efficiently Re-investing Its Profits?

Looking at its three-year median payout ratio of 27% (or a retention ratio of 73%) which is pretty normal, Thermax'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.

In addition, Thermax 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. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 27%. However, Thermax's ROE is predicted to rise to 12% despite there being no anticipated change in its payout ratio.

Summary

Overall, we have mixed feelings about Thermax. While the company does have a high rate of profit retention, its low rate of return is probably hampering its earnings growth. That being so, the latest industry analyst forecasts show that the analysts are expecting to see a huge improvement in the company's earnings growth rate. 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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