Eaton’s (NYSE:ETN) stock is up by 6.6% 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 Eaton’s ROE.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
Check out our latest analysis for Eaton
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 Eaton is:
9.5% = US$1.4b ÷ US$15b (Based on the trailing twelve months to March 2021).
The ‘return’ refers to a company’s earnings over the last year. That means that for every $1 worth of shareholders’ equity, the company generated $0.10 in profit.
Why Is ROE Important For Earnings Growth?
So far, we’ve learned that ROE is a measure of a company’s profitability. We now need to evaluate how much profit the company reinvests or “retains” for future growth which then gives us an idea about the growth potential of the company. 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.
A Side By Side comparison of Eaton’s Earnings Growth And 9.5% ROE
On the face of it, Eaton’s ROE is not much to talk about. A quick further study shows that the company’s ROE doesn’t compare favorably to the industry average of 12% either. Given the circumstances, the significant decline in net income by 5.1% seen by Eaton over the last five years is not surprising. We believe that there also might be other aspects that are negatively influencing the company’s earnings prospects. Such as – low earnings retention or poor allocation of capital.
That being said, we compared Eaton’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 8.9% in the same period.
Earnings growth is an important metric to consider when valuing a stock. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. This then helps them determine if the stock is placed for a bright or bleak future. Is Eaton fairly valued compared to other companies? These 3 valuation measures might help you decide.
Is Eaton Efficiently Re-investing Its Profits?
Eaton has a high three-year median payout ratio of 53% (that is, it is retaining 47% of its profits). This suggests that the company is paying most of its profits as dividends to its shareholders. This goes some way in explaining why its earnings have been shrinking. With only very little left to reinvest into the business, growth in earnings is far from likely. Our risks dashboard should have the 2 risks we have identified for Eaton.
Moreover, Eaton 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 over the next three years is expected to be approximately 46%. Still, forecasts suggest that Eaton’s future ROE will rise to 17% even though the the company’s payout ratio is not expected to change by much.
Summary
Overall, we would be extremely cautious before making any decision on Eaton. 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.
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.