Can Orica Limited's (ASX:ORI) Weak Financials Pull The Plug On The Stock's Current Momentum On Its Share Price?

editorial-team@simplywallst.com (Simply Wall St)

Sat, Nov 25, 2023, 4:01 PM 4 min read

Orica (ASX:ORI) has had a great run on the share market with its stock up by a significant 6.6% over the last month. However, we decided to pay close attention to its weak financials as we are doubtful that the current momentum will keep up, given the scenario. Specifically, we decided to study Orica's ROE in this article.

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.

View our latest analysis for Orica

How Do You Calculate Return On Equity?

The formula for ROE is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Orica is:

6.2% = AU$251m ÷ AU$4.1b (Based on the trailing twelve months to September 2023).

The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each A$1 of shareholders' capital it has, the company made A$0.06 in profit.

What Has ROE Got To Do With Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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. 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.

Orica's Earnings Growth And 6.2% ROE

At first glance, Orica's ROE doesn't look very promising. However, given that the company's ROE is similar to the average industry ROE of 5.3%, we may spare it some thought. Having said that, Orica's net income growth over the past five years is more or less flat. Remember, the company's ROE is not particularly great to begin with. So that could also be one of the reasons behind the company's flat growth in earnings.

We then compared Orica's net income growth with the industry and found that the average industry growth rate was 14% in the same 5-year period.

past-earnings-growth — ASX:ORI Past Earnings Growth November 25th 2023

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. 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 ORI? You can find out in our latest intrinsic value infographic research report.

Is Orica Using Its Retained Earnings Effectively?

Orica has a high three-year median payout ratio of 66% (or a retention ratio of 34%), meaning that the company is paying most of its profits as dividends to its shareholders. This does go some way in explaining why there's been no growth in its earnings.

Moreover, Orica has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over earnings growth. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 52% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 12%, over the same period.

Conclusion

In total, we would have a hard think before deciding on any investment action concerning Orica. As a result of its low ROE and lack of much reinvestment into the business, the company has seen a disappointing earnings growth rate. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.

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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.