Contact Energy Limited's (NZSE:CEN) Financial Prospects Don't Look Very Positive: Could It Mean A Stock Price Drop In The Future?

Contact Energy's (NZSE:CEN) stock is up by 6.6% over the past three months. However, in this article, we decided to focus on its weak financials, as long-term fundamentals ultimately dictate market outcomes. Particularly, we will be paying attention to Contact Energy's ROE today.

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. 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?

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 Contact Energy is:

9.0% = NZ$235m ÷ NZ$2.6b (Based on the trailing twelve months to June 2024).

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$0.09 in profit.

What Is The Relationship Between ROE And Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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 everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.

Contact Energy's Earnings Growth And 9.0% ROE

At first glance, Contact Energy's ROE doesn't look very promising. However, given that the company's ROE is similar to the average industry ROE of 9.0%, we may spare it some thought. On the other hand, Contact Energy reported a moderate 5.0% net income growth over the past five years. Given the slightly low ROE, it is likely that there could be some other aspects that are driving this growth. Such as - high earnings retention or an efficient management in place.

We then compared Contact Energy's net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 7.3% in the same 5-year period, which is a bit concerning.

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

Is Contact Energy Efficiently Re-investing Its Profits?

Contact Energy's high three-year median payout ratio of 138% suggests that the company is paying out more to its shareholders than what it is making. Still the company's earnings have grown respectably. That being said, the high payout ratio could be worth keeping an eye on in case the company is unable to keep up its current growth momentum.

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's future payout ratio is expected to drop to 91% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 13%, over the same period.

Conclusion

On the whole, Contact Energy's performance is quite a big let-down. While no doubt its earnings growth is pretty respectable, its ROE and earnings retention is quite poor. So while the company has managed to grow its earnings in spite of this, we are unconvinced if this growth could extend, specially during troubled times. We also studied the latest analyst forecasts and found that the company's earnings growth is expected be similar to its current growth rate. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.

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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.