With its stock down 6.6% over the past month, it is easy to disregard Eastman Chemical (NYSE:EMN). It seems that the market might have completely ignored the positive aspects of the company's fundamentals and decided to weigh-in more on the negative aspects. Fundamentals usually dictate market outcomes so it makes sense to study the company's financials. Particularly, we will be paying attention to Eastman Chemical's ROE today.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
How To Calculate Return On Equity?
The formula for ROE is:
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$506m ÷ US$6.3b (Based on the trailing twelve months to March 2021).
The 'return' is the profit over the last twelve months. Another way to think of that is that for every $1 worth of equity, the company was able to earn $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. 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.
Eastman Chemical's Earnings Growth And 8.0% ROE
On the face of it, Eastman Chemical's ROE is not much to talk about. 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 12%. For this reason, Eastman Chemical's five year net income decline of 10% is not surprising given its lower ROE. We believe that there also might be other aspects that are negatively influencing the company's earnings prospects. 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 3.3% in the same period.
Earnings growth is an important metric to consider when valuing a stock. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. This then helps them determine if the stock is placed for a bright or bleak future. Is EMN fairly valued? This infographic on the company's intrinsic value has everything you need to know.
Is Eastman Chemical Efficiently Re-investing Its Profits?
Despite having a normal three-year median payout ratio of 43% (where it is retaining 57% of its profits), Eastman Chemical has seen a decline in earnings as we saw above. 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. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 33% over the next three years. The fact that the company's ROE is expected to rise to 19% over the same period is explained by the drop in the payout ratio.
In total, we're a bit ambivalent about Eastman Chemical's performance. 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. 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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