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Downer EDI Limited's (ASX:DOW) Stock's Been Going Strong: Could Weak Financials Mean The Market Will Correct Its Share Price?

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·4-min read
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Downer EDI's (ASX:DOW) stock is up by a considerable 21% over the past three months. However, in this article, we decided to focus on its weak fundamentals, as long-term financial performance of a business is what ultimatley dictates market outcomes. Specifically, we decided to study Downer EDI'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. Put another way, it reveals the company's success at turning shareholder investments into profits.

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:

6.2% = AU$184m ÷ AU$3.0b (Based on the trailing twelve months to June 2021).

The 'return' is the profit over the last twelve months. That means that for every A$1 worth of shareholders' equity, the company generated A$0.06 in profit.

What Is The Relationship Between ROE And Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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 everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.

Downer EDI's Earnings Growth And 6.2% ROE

When you first look at it, Downer EDI's ROE doesn't look that attractive. Next, when compared to the average industry ROE of 9.8%, the company's ROE leaves us feeling even less enthusiastic. Therefore, it might not be wrong to say that the five year net income decline of 26% seen by Downer EDI was probably the result of it having a lower ROE. However, there could also be other factors causing the earnings to decline. For example, it is possible that the business has allocated capital poorly or that the company has a very high payout ratio.

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 0.6% in the same period.

past-earnings-growth
past-earnings-growth

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. Doing so will help them establish if the stock's future looks promising or ominous. Has the market priced in the future outlook for DOW? You can find out in our latest intrinsic value infographic research report.

Is Downer EDI Making Efficient Use Of Its Profits?

Downer EDI's declining earnings is not surprising given how the company is spending most of its profits in paying dividends, judging by its three-year median payout ratio of 79% (or a retention ratio of 21%). With only a little being reinvested into the business, earnings growth would obviously be low or non-existent. You can see the 2 risks we have identified for Downer EDI by visiting our risks dashboard for free on our platform here.

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. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 62% over the next three years. As a result, the expected drop in Downer EDI's payout ratio explains the anticipated rise in the company's future ROE to 11%, over the same period.

Summary

On the whole, Downer EDI's performance is quite a big let-down. 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.

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 (at) simplywallst.com.

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