Discovery Limited's (JSE:DSY) Stock Is Rallying But Financials Look Ambiguous: Will The Momentum Continue?

Discovery (JSE:DSY) has had a great run on the share market with its stock up by a significant 22% over the last three months. However, we decided to pay attention to the company's fundamentals which don't appear to give a clear sign about the company's financial health. Specifically, we decided to study Discovery'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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

Check out our latest analysis for Discovery

How Is ROE Calculated?

ROE 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 Discovery is:

10% = R5.4b ÷ R52b (Based on the trailing twelve months to December 2023).

The 'return' is the profit over the last twelve months. One way to conceptualize this is that for each ZAR1 of shareholders' capital it has, the company made ZAR0.10 in profit.

Why Is ROE Important For 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.

Discovery's Earnings Growth And 10% ROE

It is hard to argue that Discovery's ROE is much good in and of itself. Even when compared to the industry average of 14%, the ROE figure is pretty disappointing. Accordingly, Discovery's low net income growth of 3.5% over the past five years can possibly be explained by the low ROE amongst other factors.

We then compared Discovery's net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 5.4% in the same 5-year period, which is a bit concerning.

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. One good indicator of expected earnings growth is the P/E ratio which determines the price the market is willing to pay for a stock based on its earnings prospects. So, you may want to check if Discovery is trading on a high P/E or a low P/E, relative to its industry.

Is Discovery Efficiently Re-investing Its Profits?

A low three-year median payout ratio of 14% (implying that the company retains the remaining 86% of its income) suggests that Discovery is retaining most of its profits. This should be reflected in its earnings growth number, but that's not the case. So there could be some other explanation in that regard. For instance, the company's business may be deteriorating.

Additionally, Discovery has paid dividends over a period of at least ten years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to rise to 18% over the next three years. Still, forecasts suggest that Discovery's future ROE will rise to 14% even though the the company's payout ratio is expected to rise. We presume that there could some other characteristics of the business that could be driving the anticipated growth in the company's ROE.

Conclusion

In total, we're a bit ambivalent about Discovery's performance. While the company does have a high rate of reinvestment, the low ROE means that all that reinvestment is not reaping any benefit to its investors, and moreover, its having a negative impact on the earnings growth. With that said, the latest industry analyst forecasts reveal that the company's earnings are expected to accelerate. 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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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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com