With its stock down 3.8% over the past three months, it is easy to disregard Trustpower (NZSE:TPW). Given that stock prices are usually driven by a company’s fundamentals over the long term, which in this case look pretty weak, we decided to study the company's key financial indicators. In this article, we decided to focus on Trustpower's ROE.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
How Is ROE Calculated?
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 Trustpower is:
8.9% = NZ$98m ÷ NZ$1.1b (Based on the trailing twelve months to March 2020).
The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each NZ$1 of shareholders' capital it has, the company made NZ$0.09 in profit.
What Is The Relationship Between ROE And 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.
Trustpower's Earnings Growth And 8.9% ROE
When you first look at it, Trustpower's ROE doesn't look that attractive. However, its ROE is similar to the industry average of 8.9%, so we won't completely dismiss the company. But then again, Trustpower's five year net income shrunk at a rate of 4.7%. Bear in mind, the company does have a slightly low ROE. So that's what might be causing earnings growth to shrink.
That being said, we compared Trustpower'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 15% in the same period.
Earnings growth is a huge factor in stock valuation. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Has the market priced in the future outlook for TPW? You can find out in our latest intrinsic value infographic research report.
Is Trustpower Making Efficient Use Of Its Profits?
Trustpower's very high three-year median payout ratio of 114% over the last three years suggests that the company is paying its shareholders more than what it is earning and this explains the company's shrinking earnings. Paying a dividend beyond their means is usually not viable over the long term. Our risks dashboard should have the 3 risks we have identified for Trustpower.
Additionally, Trustpower has paid dividends over a period of four 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 over the next three years is expected to be approximately 114%. Therefore, the company's future ROE is also not expected to change by much with analysts predicting an ROE of 8.6%.
On the whole, Trustpower's performance is quite a big let-down. Specifically, it has shown quite an unsatisfactory performance as far as earnings growth is concerned, and a poor ROE and an equally poor rate of reinvestment seem to be the reason behind this inadequate performance. With that said, we studied current analyst estimates and discovered that analysts expect the company's earnings growth to improve slightly. Sure enough, this could bring some relief to shareholders. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts 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.
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