Meridian Energy (NZSE:MEL) has had a great run on the share market with its stock up by a significant 19% over the last three months. However, we decided to pay attention to the company's fundamentals which don't appear to give a clear sign about the company's financial health. Specifically, we decided to study Meridian 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. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.
How To Calculate Return On Equity?
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 Meridian Energy is:
3.5% = NZ$176m ÷ NZ$5.1b (Based on the trailing twelve months to June 2020).
The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each NZ$1 of shareholders' capital it has, the company made NZ$0.03 in profit.
What Has ROE Got To Do With 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. 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.
A Side By Side comparison of Meridian Energy's Earnings Growth And 3.5% ROE
As you can see, Meridian Energy's ROE looks pretty weak. An industry comparison shows that the company's ROE is not much different from the industry average of 3.1% either. As a result, Meridian Energy's decent 7.5% net income growth seen over the past five years bodes well with us. We reckon that there could also be other factors at play that are influencing the company's growth. For example, it is possible that the company's management has made some good strategic decisions, or that the company has a low payout ratio.
We then performed a comparison between Meridian Energy's net income growth with the industry, which revealed that the company's growth is similar to the average industry growth of 9.0% in the same period.
Earnings growth is an important metric to consider when valuing a stock. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). Doing so will help them establish if the stock's future looks promising or ominous. Is Meridian Energy fairly valued compared to other companies? These 3 valuation measures might help you decide.
Is Meridian Energy Using Its Retained Earnings Effectively?
The really high three-year median payout ratio of 167% for Meridian Energy suggests that the company is paying its shareholders more than what it is earning. In spite of this, the company was able to grow its earnings respectably, as we saw above. It would still be worth keeping an eye on that high payout ratio, if for some reason the company runs into problems and business deteriorates. To know the 2 risks we have identified for Meridian Energy visit our risks dashboard for free.
Besides, Meridian Energy has been paying dividends over a period of six years. This shows that the company is committed to sharing profits with its shareholders. Our latest analyst data shows that the future payout ratio of the company is expected to rise to 264% over the next three years. Still, forecasts suggest that Meridian Energy's future ROE will rise to 4.7% even though the the company's payout ratio is expected to rise. We presume that there could some other characteristics of the business that could be driving the anticipated growth in the company's ROE.
In total, we're a bit ambivalent about Meridian Energy's performance. While no doubt its earnings growth is pretty substantial, 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, especially during troubled times. With that said, the latest industry analyst forecasts reveal that the company's earnings growth is expected to slow down. 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. 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.
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