Trustpower Limited's (NZSE:TPW) Has Been On A Rise But Financial Prospects Look Weak: Is The Stock Overpriced?

Trustpower's (NZSE:TPW) stock is up by a considerable 17% over the past three months. However, in this article, we decided to focus on its weak fundamentals, as long-term financial performance of a business is what ultimatley dictates market outcomes. In this article, we decided to focus on Trustpower's ROE.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

Check out our latest analysis for Trustpower

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 Trustpower is:

8.4% = NZ$93m ÷ NZ$1.1b (Based on the trailing twelve months to September 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$0.08 in profit.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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 Trustpower's Earnings Growth And 8.4% ROE

At first glance, Trustpower's ROE doesn't look very promising. However, the fact that the company's ROE is higher than the average industry ROE of 5.5%, is definitely interesting. Having said that, Trustpower's net income growth over the past five years is more or less flat. Remember, the company's ROE is a bit low to begin with, just that it is higher than the industry average. Hence, this goes some way in explaining the flat earnings growth.

As a next step, we compared Trustpower's net income growth with the industry and were disappointed to see that the company's growth is lower than the industry average growth of 21% 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. Doing so will help them establish if the stock's future looks promising or ominous. Has the market priced in the future outlook for TPW? You can find out in our latest intrinsic value infographic research report.

Is Trustpower Making Efficient Use Of Its Profits?

Trustpower's very high three-year median payout ratio of 111% suggests that the company is paying its shareholders more than what it is earning. The absence in growth is therefore not surprising. Paying a dividend beyond their means is usually not viable over the long term. That's a huge risk in our books. To know the 2 risks we have identified for Trustpower visit our risks dashboard for free.

In addition, Trustpower has been paying dividends over a period of four years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 99% of its profits over the next three years. Therefore, the company's future ROE is also not expected to change by much with analysts predicting an ROE of 10.0%.

Conclusion

In total, we would have a hard think before deciding on any investment action concerning Trustpower. The company has shown a disappointing growth in its earnings as a result of it retaining little to almost none of its profits. So, the decent ROE it does have, is not much useful to investors given that the company is reinvesting very little into its business. Having said that, looking at the current analyst estimates, we found that the company's earnings are expected to gain momentum. 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. 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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