Energy Recovery, Inc.'s (NASDAQ:ERII) Stock Is Rallying But Financials Look Ambiguous: Will The Momentum Continue?

Energy Recovery (NASDAQ:ERII) has had a great run on the share market with its stock up by a significant 8.1% over the last week. 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. Particularly, we will be paying attention to Energy Recovery's ROE today.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. Put another way, it reveals the company's success at turning shareholder investments into profits.

Check out our latest analysis for Energy Recovery

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 Energy Recovery is:

9.8% = US$22m ÷ US$220m (Based on the trailing twelve months to December 2023).

The 'return' is the yearly profit. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.10 in profit.

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. 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.

Energy Recovery's Earnings Growth And 9.8% ROE

At first glance, Energy Recovery's ROE doesn't look very promising. Next, when compared to the average industry ROE of 14%, the company's ROE leaves us feeling even less enthusiastic. For this reason, Energy Recovery's five year net income decline of 4.2% is not surprising given its lower ROE. We believe that there also might be other aspects that are negatively influencing the company's earnings prospects. Such as - low earnings retention or poor allocation of capital.

However, when we compared Energy Recovery's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 7.4% in the same period. This is quite worrisome.

Earnings growth is a huge factor in stock valuation. 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 Energy Recovery fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Energy Recovery Efficiently Re-investing Its Profits?

Energy Recovery doesn't pay any regular dividends, meaning that potentially all of its profits are being reinvested in the business, which doesn't explain why the company's earnings have shrunk if it is retaining all of its profits. So there could be some other explanations in that regard. For instance, the company's business may be deteriorating.

Conclusion

Overall, we have mixed feelings about Energy Recovery. While the company does have a high rate of profit retention, its low rate of return is probably hampering its earnings growth. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. 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.