It is hard to get excited after looking at Dover's (NYSE:DOV) recent performance, when its stock has declined 4.7% over the past month. However, the company's fundamentals look pretty decent, and long-term financials are usually aligned with future market price movements. Specifically, we decided to study Dover'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 other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
How Is ROE Calculated?
Return on equity 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 Dover is:
20% = US$683m ÷ US$3.4b (Based on the trailing twelve months to December 2020).
The 'return' refers to a company's earnings over the last year. That means that for every $1 worth of shareholders' equity, the company generated $0.20 in profit.
What Is The Relationship Between ROE And Earnings Growth?
We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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.
A Side By Side comparison of Dover's Earnings Growth And 20% ROE
To start with, Dover's ROE looks acceptable. On comparing with the average industry ROE of 11% the company's ROE looks pretty remarkable. Despite this, Dover's five year net income growth was quite low averaging at only 4.9%. This is interesting as the high returns should mean that the company has the ability to generate high growth but for some reason, it hasn't been able to do so. We reckon that a low growth, when returns are quite high could be the result of certain circumstances like low earnings retention or poor allocation of capital.
Next, on comparing with the industry net income growth, we found that Dover's reported growth was lower than the industry growth of 8.1% in the same period, which is not something we like to see.
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. This then helps them determine if the stock is placed for a bright or bleak future. Has the market priced in the future outlook for DOV? You can find out in our latest intrinsic value infographic research report.
Is Dover Using Its Retained Earnings Effectively?
Despite having a moderate three-year median payout ratio of 42% (implying that the company retains the remaining 58% of its income), Dover's earnings growth was quite low. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.
Moreover, Dover has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over earnings growth. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 29% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 25%, over the same period.
Overall, we feel that Dover certainly does have some positive factors to consider. Yet, the low earnings growth is a bit concerning, especially given that the company has a high rate of return and is reinvesting ma huge portion of its profits. By the looks of it, there could be some other factors, not necessarily in control of the business, that's preventing growth. With that said, the latest industry analyst forecasts reveal that the company's earnings are expected to accelerate. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.
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