Contact Energy Limited (NZSE:CEN) Is Up But Financials Look Inconsistent: Which Way Is The Stock Headed?

Most readers would already know that Contact Energy's (NZSE:CEN) stock increased by 2.8% over the past month. However, we decided to study the company's mixed-bag of fundamentals to assess what this could mean for future share prices, as stock prices tend to be aligned with a company's long-term financial performance. In this article, we decided to focus on Contact Energy's ROE.

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.

View our latest analysis for Contact Energy

How To 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 Contact Energy is:

8.2% = NZ$243m ÷ NZ$3.0b (Based on the trailing twelve months to December 2021).

The 'return' is the yearly profit. So, this means that for every NZ$1 of its shareholder's investments, the company generates a profit of NZ$0.08.

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. 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. 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.

Contact Energy's Earnings Growth And 8.2% ROE

On the face of it, Contact Energy's ROE is not much to talk about. Yet, a closer study shows that the company's ROE is similar to the industry average of 9.6%. Even so, Contact Energy has shown a fairly decent growth in its net income which grew at a rate of 10.0%. Taking into consideration that the ROE is not particularly high, we reckon that there could also be other factors at play which could be influencing the company's growth. For instance, the company has a low payout ratio or is being managed efficiently.

As a next step, we compared Contact Energy's net income growth with the industry, and pleasingly, we found that the growth seen by the company is higher than the average industry growth of 3.3%.

Earnings growth is a huge factor in stock valuation. 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. Has the market priced in the future outlook for CEN? You can find out in our latest intrinsic value infographic research report.

Is Contact Energy Using Its Retained Earnings Effectively?

The really high three-year median payout ratio of 175% for Contact Energy suggests that the company is paying its shareholders more than what it is earning. However, this hasn't really hampered its ability to grow as we saw earlier. Although, the high payout ratio is certainly something we would keep an eye on if the company is not able to keep up its growth, or if business deteriorates. To know the 2 risks we have identified for Contact Energy visit our risks dashboard for free.

Moreover, Contact Energy is determined to keep sharing its profits with shareholders which we infer from its long history of paying a dividend for at least ten years. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 144% of its profits over the next three years. As a result, Contact Energy's ROE is not expected to change by much either, which we inferred from the analyst estimate of 7.9% for future ROE.

Summary

On the whole, we feel that the performance shown by Contact Energy can be open to many interpretations. Although the company has shown a pretty impressive growth in earnings, yet the low ROE and the low rate of reinvestment makes us skeptical about the continuity of that growth, especially when or if the business comes to face any threats. That being so, according to the latest industry analyst forecasts, the company's earnings are expected to shrink in the future. 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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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.