Should Weakness in Xylem Inc.'s (NYSE:XYL) Stock Be Seen As A Sign That Market Will Correct The Share Price Given Decent Financials?

With its stock down 17% over the past three months, it is easy to disregard Xylem (NYSE:XYL). However, the company's fundamentals look pretty decent, and long-term financials are usually aligned with future market price movements. Particularly, we will be paying attention to Xylem's ROE today.

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

View our latest analysis for Xylem

How To Calculate Return On Equity?

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 Xylem is:

7.8% = US$830m ÷ US$11b (Based on the trailing twelve months to September 2024).

The 'return' is the income the business earned 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 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 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.

Xylem's Earnings Growth And 7.8% ROE

At first glance, Xylem's ROE doesn't look very promising. We then compared the company's ROE to the broader industry and were disappointed to see that the ROE is lower than the industry average of 15%. Although, we can see that Xylem saw a modest net income growth of 16% over the past five years. So, there might be other aspects that are positively influencing the company's earnings growth. Such as - high earnings retention or an efficient management in place.

Next, on comparing Xylem's net income growth with the industry, we found that the company's reported growth is similar to the industry average growth rate of 15% over the last few years.

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. What is XYL worth today? The intrinsic value infographic in our free research report helps visualize whether XYL is currently mispriced by the market.

Is Xylem Using Its Retained Earnings Effectively?

Xylem has a three-year median payout ratio of 49%, which implies that it retains the remaining 51% of its profits. This suggests that its dividend is well covered, and given the decent growth seen by the company, it looks like management is reinvesting its earnings efficiently.

Additionally, Xylem has paid dividends over a period of at least ten years which means that the company is pretty serious about sharing its profits with shareholders. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 29% over the next three years. As a result, the expected drop in Xylem's payout ratio explains the anticipated rise in the company's future ROE to 11%, over the same period.

Conclusion

On the whole, we do feel that Xylem has some positive attributes. Even in spite of the low rate of return, the company has posted impressive earnings growth as a result of reinvesting heavily into its business. The latest industry analyst forecasts show that the company is expected to maintain its current growth rate. 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. 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.