Norsk Hydro (OB:NHY) has had a great run on the share market with its stock up by a significant 26% 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 Norsk Hydro's ROE today.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.
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 Norsk Hydro is:
2.1% = kr1.7b ÷ kr77b (Based on the trailing twelve months to December 2020).
The 'return' is the yearly profit. That means that for every NOK1 worth of shareholders' equity, the company generated NOK0.02 in profit.
Why Is ROE Important For 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. 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.
Norsk Hydro's Earnings Growth And 2.1% ROE
It is quite clear that Norsk Hydro's ROE is rather low. Not just that, even compared to the industry average of 10%, the company's ROE is entirely unremarkable. Given the circumstances, the significant decline in net income by 36% seen by Norsk Hydro over the last five years is not surprising. However, there could also be other factors causing the earnings to decline. For instance, the company has a very high payout ratio, or is faced with competitive pressures.
However, when we compared Norsk Hydro's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 14% in the same period. This is quite worrisome.
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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is NHY fairly valued? This infographic on the company's intrinsic value has everything you need to know.
Is Norsk Hydro Making Efficient Use Of Its Profits?
Despite having a normal three-year median payout ratio of 37% (where it is retaining 63% of its profits), Norsk Hydro has seen a decline in earnings as we saw above. So there could be some other explanations in that regard. For instance, the company's business may be deteriorating.
Moreover, Norsk Hydro 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. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 43% of its profits over the next three years. Still, forecasts suggest that Norsk Hydro's future ROE will rise to 9.7% even though the the company's payout ratio is not expected to change by much.
On the whole, we feel that the performance shown by Norsk Hydro can be open to many interpretations. 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 current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.
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