Eastman Chemical's (NYSE:EMN) stock up by 9.8% over the past three months. However, we decided to study the company's mixed-bag of fundamentals to assess what this could mean for future share prices, as stock prices tend to be aligned with a company's long-term financial performance. Specifically, we decided to study Eastman Chemical'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 short, ROE shows the profit each dollar generates with respect to its shareholder investments.
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 Eastman Chemical is:
8.0% = US$489m ÷ US$6.1b (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 $0.08 in profit.
Why Is ROE Important For Earnings Growth?
So far, we've learned that ROE is a measure of a company's profitability. 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.
Eastman Chemical's Earnings Growth And 8.0% ROE
When you first look at it, Eastman Chemical's ROE doesn't look that attractive. A quick further study shows that the company's ROE doesn't compare favorably to the industry average of 10% either. For this reason, Eastman Chemical's five year net income decline of 6.8% is not surprising given its lower ROE. However, there could also be other factors causing the earnings to decline. For instance, the company has a very high payout ratio, or is faced with competitive pressures.
So, as a next step, we compared Eastman Chemical's performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 5.3% in the same period.
Earnings growth is an important metric to consider when valuing a stock. 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 EMN worth today? The intrinsic value infographic in our free research report helps visualize whether EMN is currently mispriced by the market.
Is Eastman Chemical Using Its Retained Earnings Effectively?
In spite of a normal three-year median payout ratio of 37% (that is, a retention ratio of 63%), the fact that Eastman Chemical's earnings have shrunk is quite puzzling. It looks like there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.
In addition, Eastman Chemical has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 37%. Still, forecasts suggest that Eastman Chemical's future ROE will rise to 22% even though the the company's payout ratio is not expected to change by much.
Overall, we have mixed feelings about Eastman Chemical. Even though it appears to be retaining most of its profits, given the low ROE, investors may not be benefitting from all that reinvestment after all. The low earnings growth suggests our theory correct. 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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