It is hard to get excited after looking at Contact Energy's (NZSE:CEN) recent performance, when its stock has declined 4.1% over the past month. We decided to study the company's financials to determine if the downtrend will continue as the long-term performance of a company usually dictates market outcomes. Specifically, we decided to study Contact Energy'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 To Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Contact Energy is:
4.5% = NZ$127m ÷ NZ$2.8b (Based on the trailing twelve months to June 2023).
The 'return' refers to a company's earnings over the last year. Another way to think of that is that for every NZ$1 worth of equity, the company was able to earn NZ$0.05 in profit.
What Has ROE Got To Do With Earnings Growth?
We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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.
A Side By Side comparison of Contact Energy's Earnings Growth And 4.5% ROE
When you first look at it, Contact Energy's 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 8.0%. Therefore, Contact Energy's flat earnings 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 Contact Energy's earnings seems to be shrinking at a similar rate as the industry which shrunk at a rate of a rate of 1.2% in the same period.
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 Contact Energy fairly valued compared to other companies? These 3 valuation measures might help you decide.
Is Contact Energy Using Its Retained Earnings Effectively?
Contact Energy has a three-year median payout ratio as high as 185% meaning that the company is paying a dividend which is beyond its means. The absence of growth in Contact Energy's earnings therefore, doesn't come as a surprise. Its usually very hard to sustain dividend payments that are higher than reported profits. This is indicative of risk. You can see the 2 risks we have identified for Contact Energy by visiting our risks dashboard for free on our platform here.
Additionally, Contact Energy 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. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 105% over the next three years. As a result, the expected drop in Contact Energy's payout ratio explains the anticipated rise in the company's future ROE to 11%, over the same period.
In total, we would have a hard think before deciding on any investment action concerning Contact Energy. Specifically, it has shown quite an unsatisfactory performance as far as earnings growth is concerned, and a poor ROE and an equally poor rate of reinvestment seem to be the reason behind this inadequate performance. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.
Valuation is complex, but we're helping make it simple.
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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.