Most readers would already be aware that India Power's (NSE:DPSCLTD) stock increased significantly by 18% over the past three months. However, we wonder if the company's inconsistent financials would have any adverse impact on the current share price momentum. Specifically, we decided to study India Power's ROE in this article.
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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
How Do You Calculate Return On Equity?
Return on equity 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 India Power is:
1.5% = ₹247m ÷ ₹16b (Based on the trailing twelve months to December 2020).
The 'return' is the yearly profit. So, this means that for every ₹1 of its shareholder's investments, the company generates a profit of ₹0.02.
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 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.
India Power's Earnings Growth And 1.5% ROE
It is hard to argue that India Power's ROE is much good in and of itself. Even compared to the average industry ROE of 7.5%, the company's ROE is quite dismal. Therefore, it might not be wrong to say that the five year net income decline of 48% seen by India Power was possibly a result of it having a lower ROE. We reckon that there could also be other factors at play here. For instance, the company has a very high payout ratio, or is faced with competitive pressures.
That being said, we compared India Power'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 11% in the same period.
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. Doing so will help them establish if the stock's future looks promising or ominous. If you're wondering about India Power's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.
Is India Power Using Its Retained Earnings Effectively?
When we piece together India Power's low three-year median payout ratio of 17% (where it is retaining 83% of its profits), calculated for the last three-year period, we are puzzled by the lack of growth. The low payout should mean that the company is retaining most of its earnings and consequently, should see some growth. So there could be some other explanations in that regard. For example, the company's business may be deteriorating.
Additionally, India Power has paid dividends over a period of at least ten years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth.
Overall, we have mixed feelings about India Power. 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. Wrapping up, we would proceed with caution with this company and one way of doing that would be to look at the risk profile of the business. Our risks dashboard would have the 2 risks we have identified for India Power.
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