Is The Market Rewarding Energy Recovery, Inc. (NASDAQ:ERII) With A Negative Sentiment As A Result Of Its Mixed Fundamentals?

It is hard to get excited after looking at Energy Recovery's (NASDAQ:ERII) recent performance, when its stock has declined 11% over the past week. We, however decided to study the company's financials to determine if they have got anything to do with the price decline. Fundamentals usually dictate market outcomes so it makes sense to study the company's financials. In this article, we decided to focus on Energy Recovery's ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

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:

8.3% = US$19m ÷ US$234m (Based on the trailing twelve months to September 2024).

The 'return' refers to a company's earnings over the last year. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.08.

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. 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.

Energy Recovery's Earnings Growth And 8.3% ROE

On the face of it, Energy Recovery's ROE is not much to talk about. A quick further study shows that the company's ROE doesn't compare favorably to the industry average of 15% either. As a result, Energy Recovery's flat net income growth over the past five years doesn't come as a surprise given its lower ROE.

We then compared Energy Recovery's net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 16% in the same 5-year period, which is a bit concerning.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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. 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 Energy Recovery is trading on a high P/E or a low P/E, relative to its industry.

Is Energy Recovery Efficiently Re-investing Its Profits?

Energy Recovery doesn't pay any regular dividends, meaning that the company is keeping all of its profits, which makes us wonder why it is retaining its earnings if it can't use them to grow its business. So there could be some other explanations in that regard. For instance, the company's business may be deteriorating.

Conclusion

On the whole, we feel that the performance shown by Energy Recovery can be open to many interpretations. 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, the latest industry analyst forecasts reveal that the company's earnings are expected to accelerate. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.