Downer EDI Limited's (ASX:DOW) Financial Prospects Don't Look Very Positive: Could It Mean A Stock Price Drop In The Future?
Downer EDI's (ASX:DOW) stock up by 9.6% over the past three months. However, its weak financial performance indicators makes us a bit doubtful if that trend could continue. Particularly, we will be paying attention to Downer EDI's ROE today.
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
View our latest analysis for Downer EDI
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 Downer EDI is:
6.8% = AU$197m ÷ AU$2.9b (Based on the trailing twelve months to December 2021).
The 'return' is the amount earned after tax over the last twelve months. One way to conceptualize this is that for each A$1 of shareholders' capital it has, the company made A$0.07 in profit.
Why Is ROE Important For Earnings Growth?
Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don’t share these attributes.
Downer EDI's Earnings Growth And 6.8% ROE
When you first look at it, Downer EDI's ROE doesn't look that attractive. However, its ROE is similar to the industry average of 7.0%, so we won't completely dismiss the company. But Downer EDI saw a five year net income decline of 16% over the past five years. Bear in mind, the company does have a slightly low ROE. So that's what might be causing earnings growth to shrink.
That being said, we compared Downer EDI's performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 4.3% in the same period.
Earnings growth is a huge factor in stock valuation. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. If you're wondering about Downer EDI's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.
Is Downer EDI Making Efficient Use Of Its Profits?
With a high three-year median payout ratio of 79% (implying that 21% of the profits are retained), most of Downer EDI's profits are being paid to shareholders, which explains the company's shrinking earnings. The business is only left with a small pool of capital to reinvest - A vicious cycle that doesn't benefit the company in the long-run. To know the 2 risks we have identified for Downer EDI visit our risks dashboard for free.
Additionally, Downer EDI has paid dividends over a period of nine years, which means that the company's management is rather focused on keeping up its dividend payments, regardless of the shrinking earnings. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 73% of its profits over the next three years. However, Downer EDI's ROE is predicted to rise to 9.8% despite there being no anticipated change in its payout ratio.
Conclusion
In total, we would have a hard think before deciding on any investment action concerning Downer EDI. As a result of its low ROE and lack of much reinvestment into the business, the company has seen a disappointing earnings growth rate. 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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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.
