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Incitec Pivot Limited (ASX:IPL) Is Going Strong But Fundamentals Appear To Be Mixed : Is There A Clear Direction For The Stock?

Most readers would already be aware that Incitec Pivot's (ASX:IPL) stock increased significantly by 11% over the past month. But the company's key financial indicators appear to be differing across the board and that makes us question whether or not the company's current share price momentum can be maintained. Specifically, we decided to study Incitec Pivot's ROE in this article.

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 short, ROE shows the profit each dollar generates with respect to its shareholder investments.

Check out our latest analysis for Incitec Pivot

How Is ROE Calculated?

ROE can be calculated by using the formula:

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

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So, based on the above formula, the ROE for Incitec Pivot is:

1.8% = AU$95m ÷ AU$5.2b (Based on the trailing twelve months to March 2021).

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 Has ROE Got To Do With Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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. 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.

Incitec Pivot's Earnings Growth And 1.8% ROE

It is quite clear that Incitec Pivot's ROE is rather low. Even when compared to the industry average of 6.0%, the ROE figure is pretty disappointing. Given the circumstances, the significant decline in net income by 13% seen by Incitec Pivot over the last five years is not surprising. We reckon that there could also be other factors at play here. Such as - low earnings retention or poor allocation of capital.

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 36% in the same period. This is quite worrisome.

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). By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. One good indicator of expected earnings growth is the P/E ratio which determines the price the market is willing to pay for a stock based on its earnings prospects. So, you may want to check if Incitec Pivot is trading on a high P/E or a low P/E, relative to its industry.

Is Incitec Pivot Efficiently Re-investing Its Profits?

Despite having a normal three-year median payout ratio of 50% (where it is retaining 50% of its profits), Incitec Pivot has seen a decline in earnings as we saw above. So there could be some other explanations in that regard. For instance, the company's business may be deteriorating.

In addition, Incitec Pivot has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 49%. Still, forecasts suggest that Incitec Pivot's future ROE will rise to 7.8% even though the the company's payout ratio is not expected to change by much.

Conclusion

Overall, we have mixed feelings about Incitec Pivot. Even though it appears to be retaining most of its profits, given the low ROE, investors may not be benefitting from all that reinvestment after all. The low earnings growth suggests our theory correct. That being so, the latest industry analyst forecasts show that the analysts are expecting to see a huge improvement in the company's earnings growth rate. 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.