Are Poor Financial Prospects Dragging Down Meridian Energy Limited (NZSE:MEL Stock?

With its stock down 6.8% over the past week, it is easy to disregard Meridian Energy (NZSE:MEL). To decide if this trend could continue, we decided to look at its weak fundamentals as they shape the long-term market trends. In this article, we decided to focus on Meridian 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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.

Check out our latest analysis for Meridian Energy

How To Calculate Return On Equity?

ROE 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 Meridian Energy is:

1.4% = NZ$85m ÷ NZ$5.9b (Based on the trailing twelve months to December 2023).

The 'return' is the yearly profit. Another way to think of that is that for every NZ$1 worth of equity, the company was able to earn NZ$0.01 in profit.

What Has ROE Got To Do With 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. 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.

Meridian Energy's Earnings Growth And 1.4% ROE

It is quite clear that Meridian Energy's ROE is rather low. Even when compared to the industry average of 2.5%, the ROE figure is pretty disappointing. For this reason, Meridian Energy's five year net income decline of 4.0% is not surprising given its lower ROE. However, there could also be other factors causing the earnings to decline. For example, the business has allocated capital poorly, or that the company has a very high payout ratio.

So, as a next step, we compared Meridian Energy's performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 35% over the last few years.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. This then helps them determine if the stock is placed for a bright or bleak future. Is MEL fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is Meridian Energy Using Its Retained Earnings Effectively?

With a three-year median payout ratio as high as 133%,Meridian Energy's shrinking earnings don't come as a surprise as the company is paying a dividend which is beyond its means. Its usually very hard to sustain dividend payments that are higher than reported profits. You can see the 2 risks we have identified for Meridian Energy by visiting our risks dashboard for free on our platform here.

In addition, Meridian Energy has been paying dividends over a period of nine years suggesting that keeping up dividend payments is preferred by the management even though earnings have been in decline. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 114% of its profits over the next three years. Regardless, the future ROE for Meridian Energy is predicted to rise to 9.0% despite there being not much change expected in its payout ratio.

Conclusion

In total, we would have a hard think before deciding on any investment action concerning Meridian Energy. Particularly, its ROE is a huge disappointment, not to mention its lack of proper reinvestment into the business. As a result its earnings growth has also been quite disappointing. That being so, the latest industry analyst forecasts show that the analysts are expecting to see a huge improvement in the company's earnings growth rate. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page 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.