Are Contact Energy Limited's (NZSE:CEN) Fundamentals Good Enough to Warrant Buying Given The Stock's Recent Weakness?

It is hard to get excited after looking at Contact Energy's (NZSE:CEN) recent performance, when its stock has declined 4.8% over the past three months. However, the company's fundamentals look pretty decent, and long-term financials are usually aligned with future market price movements. Specifically, we decided to study Contact Energy's ROE in this article.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

See our latest analysis for Contact Energy

How Is ROE Calculated?

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 Contact Energy is:

11% = NZ$287m ÷ NZ$2.7b (Based on the trailing twelve months to December 2023).

The 'return' is the income the business earned over the last year. So, this means that for every NZ$1 of its shareholder's investments, the company generates a profit of NZ$0.11.

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. 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.

Contact Energy's Earnings Growth And 11% ROE

When you first look at it, Contact Energy's ROE doesn't look that attractive. Although a closer study shows that the company's ROE is higher than the industry average of 3.6% which we definitely can't overlook. However, Contact Energy's five year net income growth was quite low averaging at only 3.4%. Bear in mind, the company does have a low ROE. It is just that the industry ROE is lower. Hence, this goes some way in explaining the low earnings growth.

Next, on comparing with the industry net income growth, we found that the growth figure reported by Contact Energy compares quite favourably to the industry average, which shows a decline of 1.4% over the last few years.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). This then helps them determine if the stock is placed for a bright or bleak future. 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 Contact Energy is trading on a high P/E or a low P/E, relative to its industry.

Is Contact Energy Making Efficient Use Of Its Profits?

Contact Energy's very high three-year median payout ratio of 150% suggests that the company is paying its shareholders more than what it is earning and it definitely contributes to the low earnings growth seen by the company. That's a huge risk in our books. To know the 2 risks we have identified for Contact Energy visit our risks dashboard for free.

Moreover, Contact Energy 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. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 111% over the next three years. However, the company's ROE is not expected to change by much despite the lower expected payout ratio.

Summary

In total, it does look like Contact Energy has some positive aspects to its business. Namely, its high earnings growth, which was probably achieved due to its respectable ROE. However, the considerably low reinvestment rate does diminish our excitement to a certain extent. With that said, the latest industry analyst forecasts reveal that the company's earnings growth is expected to slow down. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.