Tata Chemicals' (NSE:TATACHEM) stock is up by a considerable 27% over the past three months. However, we decided to pay attention to the company's fundamentals which don't appear to give a clear sign about the company's financial health. In this article, we decided to focus on Tata Chemicals' 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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.
How Is ROE Calculated?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Tata Chemicals is:
4.7% = ₹7.0b ÷ ₹151b (Based on the trailing twelve months to June 2021).
The 'return' is the amount earned after tax over the last twelve months. So, this means that for every ₹1 of its shareholder's investments, the company generates a profit of ₹0.05.
What Is The Relationship Between ROE And 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. 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.
Tata Chemicals' Earnings Growth And 4.7% ROE
As you can see, Tata Chemicals' ROE looks pretty weak. Even compared to the average industry ROE of 16%, the company's ROE is quite dismal. Therefore, it might not be wrong to say that the five year net income decline of 10.0% seen by Tata Chemicals was possibly a result of it having a lower ROE. We reckon that there could also be other factors at play here. Such as - low earnings retention or poor allocation of capital.
However, when we compared Tata Chemicals' growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 18% in the same period. This is quite worrisome.
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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is Tata Chemicals fairly valued compared to other companies? These 3 valuation measures might help you decide.
Is Tata Chemicals Using Its Retained Earnings Effectively?
Despite having a normal three-year median payout ratio of 35% (where it is retaining 65% of its profits), Tata Chemicals has seen a decline in earnings as we saw above. It looks like there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.
In addition, Tata Chemicals 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 is expected to drop to 25% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 7.9%, over the same period.
In total, we're a bit ambivalent about Tata Chemicals' performance. While the company does have a high rate of reinvestment, the low ROE means that all that reinvestment is not reaping any benefit to its investors, and moreover, its having a negative impact on the earnings growth. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.
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.
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