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Can TransAlta Renewables Inc.'s (TSE:RNW) Weak Financials Pull The Plug On The Stock's Current Momentum On Its Share Price?

Simply Wall St
·4-min read

Most readers would already be aware that TransAlta Renewables' (TSE:RNW) stock increased significantly by 26% over the past three months. We, however wanted to have a closer look at its key financial indicators as the markets usually pay for long-term fundamentals, and in this case, they don't look very promising. In this article, we decided to focus on TransAlta Renewables' ROE.

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. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

See our latest analysis for TransAlta Renewables

How Do You 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 TransAlta Renewables is:

3.9% = CA$91m ÷ CA$2.3b (Based on the trailing twelve months to September 2020).

The 'return' is the income the business earned over the last year. Another way to think of that is that for every CA$1 worth of equity, the company was able to earn CA$0.04 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. Depending on how much of these profits the company reinvests or "retains", and how effectively it does so, we are then able to assess a company’s earnings growth potential. 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.

A Side By Side comparison of TransAlta Renewables' Earnings Growth And 3.9% ROE

When you first look at it, TransAlta Renewables' ROE doesn't look that attractive. A quick further study shows that the company's ROE doesn't compare favorably to the industry average of 8.4% either. Although, we can see that TransAlta Renewables saw a modest net income growth of 11% over the past five years. We reckon that there could be other factors at play here. For example, it is possible that the company's management has made some good strategic decisions, or that the company has a low payout ratio.

We then compared TransAlta Renewables' net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 22% in the same period, which is a bit concerning.

past-earnings-growth
past-earnings-growth

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). This then helps them determine if the stock is placed for a bright or bleak future. What is RNW worth today? The intrinsic value infographic in our free research report helps visualize whether RNW is currently mispriced by the market.

Is TransAlta Renewables Using Its Retained Earnings Effectively?

TransAlta Renewables' high three-year median payout ratio of 235% suggests that the company is paying out more to its shareholders than what it is making. Still the company's earnings have grown respectably. That being said, the high payout ratio could be worth keeping an eye on in case the company is unable to keep up its current growth momentum. To know the 3 risks we have identified for TransAlta Renewables visit our risks dashboard for free.

Moreover, TransAlta Renewables is determined to keep sharing its profits with shareholders which we infer from its long history of seven years of paying a dividend. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 97% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 9.3%, over the same period.

Summary

In total, we would have a hard think before deciding on any investment action concerning TransAlta Renewables. While no doubt its earnings growth is pretty respectable, its ROE and earnings retention is quite poor. So while the company has managed to grow its earnings in spite of this, we are unconvinced if this growth could extend, specially during troubled times. We also studied the latest analyst forecasts and found that the company's earnings growth is expected be similar to its current growth rate. 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. 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.