Watts Co., Ltd.'s (TSE:2735) Stock Is Rallying But Financials Look Ambiguous: Will The Momentum Continue?

Watts (TSE:2735) has had a great run on the share market with its stock up by a significant 21% over the last 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. Particularly, we will be paying attention to Watts' ROE today.

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 short, ROE shows the profit each dollar generates with respect to its shareholder investments.

See our latest analysis for Watts

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 Watts is:

5.7% = JP¥704m ÷ JP¥12b (Based on the trailing twelve months to May 2024).

The 'return' is the yearly profit. One way to conceptualize this is that for each ¥1 of shareholders' capital it has, the company made ¥0.06 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. 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.

A Side By Side comparison of Watts' Earnings Growth And 5.7% ROE

When you first look at it, Watts' ROE doesn't look that attractive. We then compared the company's ROE to the broader industry and were disappointed to see that the ROE is lower than the industry average of 9.7%. Accordingly, Watts' low net income growth of 3.3% over the past five years can possibly be explained by the low ROE amongst other factors.

Next, on comparing with the industry net income growth, we found that Watts' reported growth was lower than the industry growth of 12% over the last few years, which is not something we like to see.

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. 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 Watts is trading on a high P/E or a low P/E, relative to its industry.

Is Watts Using Its Retained Earnings Effectively?

While Watts has a decent three-year median payout ratio of 36% (or a retention ratio of 64%), it has seen very little growth in earnings. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.

Moreover, Watts has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over earnings growth.

Summary

In total, we're a bit ambivalent about Watts' performance. 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. You can see the 1 risk we have identified for Watts by visiting our risks dashboard for free on our platform here.

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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.