It is hard to get excited after looking at Dow's (NYSE:DOW) recent performance, when its stock has declined 12% over the past three months. However, stock prices are usually driven by a company’s financial performance over the long term, which in this case looks quite promising. Particularly, we will be paying attention to Dow's ROE today.
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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
How Do You Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Dow is:
26% = US$4.2b ÷ US$16b (Based on the trailing twelve months to June 2021).
The 'return' is the amount earned after tax over the last twelve months. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.26 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. 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 everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.
A Side By Side comparison of Dow's Earnings Growth And 26% ROE
First thing first, we like that Dow has an impressive ROE. Secondly, even when compared to the industry average of 14% the company's ROE is quite impressive. This likely paved the way for the modest 5.2% net income growth seen by Dow over the past five years. growth
We then compared Dow's net income growth with the industry and we're pleased to see that the company's growth figure is higher when compared with the industry which has a growth rate of 3.3% in the same period.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). This then helps them determine if the stock is placed for a bright or bleak future. Is DOW fairly valued? This infographic on the company's intrinsic value has everything you need to know.
Is Dow Efficiently Re-investing Its Profits?
Dow has a three-year median payout ratio of 40%, which implies that it retains the remaining 60% of its profits. This suggests that its dividend is well covered, and given the decent growth seen by the company, it looks like management is reinvesting its earnings efficiently.
While Dow has been growing its earnings, it only recently started to pay dividends which likely means that the company decided to impress new and existing shareholders with a dividend. Looking at the current analyst consensus data, we can see that the company's future payout ratio is expected to rise to 50% over the next three years. Despite the higher expected payout ratio, the company's ROE is not expected to change by much.
Conclusion
Overall, we are quite pleased with Dow's performance. In particular, it's great to see that the company is investing heavily into its business and along with a high rate of return, that has resulted in a sizeable growth in its earnings. That being so, according to the latest industry analyst forecasts, the company's earnings are expected to shrink in the future. 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. 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.
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