With its stock down 14% over the past three months, it is easy to disregard Drax Group (LON:DRX). However, stock prices are usually driven by a company’s financial performance over the long term, which in this case looks quite promising. In this article, we decided to focus on Drax Group's ROE.
Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
How Do You Calculate Return On Equity?
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 Drax Group is:
11% = UK£182m ÷ UK£1.6b (Based on the trailing twelve months to June 2023).
The 'return' is the yearly profit. One way to conceptualize this is that for each £1 of shareholders' capital it has, the company made £0.11 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.
Drax Group's Earnings Growth And 11% ROE
At first glance, Drax Group seems to have a decent ROE. Further, the company's ROE is similar to the industry average of 11%. This certainly adds some context to Drax Group's exceptional 42% net income growth seen over the past five years. We believe that there might also be other aspects that are positively influencing the company's earnings growth. Such as - high earnings retention or an efficient management in place.
Next, on comparing with the industry net income growth, we found that Drax Group's growth is quite high when compared to the industry average growth of 30% in the same period, which is great to see.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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. Has the market priced in the future outlook for DRX? You can find out in our latest intrinsic value infographic research report.
Is Drax Group Efficiently Re-investing Its Profits?
The three-year median payout ratio for Drax Group is 42%, which is moderately low. The company is retaining the remaining 58%. This suggests that its dividend is well covered, and given the high growth we discussed above, it looks like Drax Group is reinvesting its earnings efficiently.
Additionally, Drax Group has paid dividends over a period of at least ten years which means that the company is pretty serious about sharing its profits with shareholders. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 26% over the next three years. As a result, the expected drop in Drax Group's payout ratio explains the anticipated rise in the company's future ROE to 17%, over the same period.
In total, we are pretty happy with Drax Group's performance. Specifically, we like that the company is reinvesting a huge chunk of its profits at a high rate of return. This of course has caused the company to see substantial growth in its earnings. With that said, the latest industry analyst forecasts reveal that the company's earnings growth is expected to slow down. 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.