With its stock down 28% over the past three months, it is easy to disregard Xylem (NYSE:XYL). However, stock prices are usually driven by a company’s financials over the long term, which in this case look pretty respectable. In this article, we decided to focus on Xylem'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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
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 Xylem is:
13% = US$427m ÷ US$3.2b (Based on the trailing twelve months to December 2021).
The 'return' is the amount earned after tax over the last twelve months. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.13.
Why Is ROE Important For Earnings Growth?
So far, we've learned that ROE is a measure of a company's profitability. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. 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 13% ROE
At first glance, Xylem seems to have a decent ROE. Further, the company's ROE compares quite favorably to the industry average of 10%. Despite this, Xylem's five year net income growth was quite low averaging at only 3.3%. 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. Such a scenario is likely to take place when a company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.
As a next step, we compared Xylem'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 8.7% in the same period.
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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is XYL fairly valued? This infographic on the company's intrinsic value has everything you need to know.
Is Xylem Using Its Retained Earnings Effectively?
Despite having a moderate three-year median payout ratio of 47% (implying that the company retains the remaining 53% of its income), Xylem's earnings growth was quite low. So there could be some other explanation in that regard. For instance, the company's business may be deteriorating.
Moreover, Xylem 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. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 35% 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 17%, over the same period.
In total, it does look like Xylem has some positive aspects to its business. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE and and a high reinvestment rate. We believe that there might be some outside factors that could be having a negative impact on the 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 latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.
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.