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Incitec Pivot's (ASX:IPL) stock up by 7.5% over the past three months. Given that the markets usually pay for the long-term financial health of a company, we wonder if the current momentum in the share price will keep up, given that the company's financials don't look very promising. In this article, we decided to focus on Incitec Pivot'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. Put another way, it reveals the company's success at turning shareholder investments into profits.
See our latest analysis for Incitec Pivot
How To 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 Incitec Pivot is:
2.4% = AU$123m ÷ AU$5.2b (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 A$1 worth of equity, the company was able to earn A$0.02 in profit.
What Is The Relationship Between ROE And Earnings Growth?
Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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. 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 Incitec Pivot's Earnings Growth And 2.4% ROE
As you can see, Incitec Pivot's ROE looks pretty weak. Even when compared to the industry average of 19%, the ROE figure is pretty disappointing. Given the circumstances, the significant decline in net income by 14% seen by Incitec Pivot over the last five years is not surprising. We reckon that there could also be other factors at play here. For example, the business has allocated capital poorly, or that the company has a very high payout ratio.
However, when we compared Incitec Pivot's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 57% in the same period. This is quite worrisome.
Earnings growth is a huge factor in stock valuation. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is Incitec Pivot fairly valued compared to other companies? These 3 valuation measures might help you decide.