Downer EDI Limited (ASX: DOW) on an uptrend but financial outlook looks pretty weak: is the stock overvalued?

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Most readers already know that Downer EDI (ASX: DOW) stock has increased significantly by 15% in the past three months. However, we wanted to take a closer look at its key financial indicators as markets typically pay for long-term fundamentals, and in this case, they don’t look very promising. In this article, we have decided to focus on the ROE of Downer EDI.

Return on equity or ROE is an important factor for a shareholder to consider because it tells them how effectively their capital is being reinvested. In short, the ROE shows the profit that each dollar generates compared to the investments of its shareholders.

See our latest review for EDI Downer

How is the ROE calculated?

Return on equity can be calculated using the formula:

Return on equity = Net income (from continuing operations) ÷ Equity

So, based on the above formula, the ROE for Downer EDI is:

6.2% = A $ 184 million ÷ A $ 3.0 billion (based on the last twelve months to June 2021).

The “return” is the amount earned after tax over the past twelve months. Another way to look at this is that for every A $ 1 worth of equity, the company was able to make A $ 0.06 in profit.

What does ROE have to do with profit growth?

So far we’ve learned that ROE is a measure of a company’s profitability. Based on how much of those profits the company reinvests or “withholds” and how efficiently it does so, we are then able to assess a company’s profit growth potential. Generally speaking, all other things being equal, companies with high return on equity and high profit retention have a higher growth rate than companies that do not share these attributes.

A side-by-side comparison of Downer EDI profit growth and 6.2% ROE

At first glance, Downer EDI’s ROE doesn’t look very promising. However, given that the company’s ROE is similar to the industry average ROE of 7.6%, we can think about it. But Downer EDI has seen its net income drop 26% over five years over the past five years. Keep in mind that the business has a slightly low ROE. Therefore, lower income could also be the result of this.

However, when we compared the growth of Downer EDI with the industry, we found that although the company’s profits declined, the industry saw 11% profit growth over the same period. . It is quite worrying.

ASX: DOW Past Profit Growth October 3, 2021

Profit growth is an important metric to consider when valuing a stock. It is important for an investor to know whether the market has factored in the expected growth (or decline) in company earnings. This will help them determine whether the future of the stock looks bright or threatening. If you’re wondering how Downer EDI is valued, check out this gauge of its price / earnings ratio, relative to its industry.

Is Downer EDI Efficiently Using Retained Earnings?

Downer EDI has a high three-year median distribution rate of 79% (i.e. it keeps 21% of its profits). This suggests that the company pays most of its profits as dividends to its shareholders. This partly explains why its profits have declined. The company has only a small reserve of capital to reinvest – a vicious cycle that does not benefit the company in the long run. Our risk dashboard should contain the 2 risks we have identified for Downer EDI.

Additionally, Downer EDI has been paying dividends for the past nine years, which is a considerable time frame, suggesting that management must have perceived that shareholders prefer constant dividends even though earnings have declined. After studying the latest consensus data from analysts, we found that the company’s future payout ratio is expected to drop to 62% over the next three years. Thus, the expected drop in the payout ratio explains the expected increase in the company’s ROE to 11% over the same period.

Summary

Overall, we would be extremely careful before making a decision on Downer EDI. The company has experienced a lack of earnings growth due to keeping very little earnings and what little it keeps is being reinvested at a very low rate of return. That said, looking at current analysts’ estimates, we found that the company’s earnings growth rate is expected to see a huge improvement. To learn more about the company’s future earnings growth forecast, take a look at this free analyst forecast report for the company to learn more.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in the mentioned stocks.

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