Treasury Wine Estates (ASX:TWE) has had a rough three months with its share price down 14%. 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 Treasury Wine Estates' 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?

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 Treasury Wine Estates is:

3.1% = AU$153m ÷ AU$4.9b (Based on the trailing twelve months to December 2024).

The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each A$1 of shareholders' capital it has, the company made A$0.03 in profit.

View our latest analysis for Treasury Wine Estates

What Has ROE Got To Do With Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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.

A Side By Side comparison of Treasury Wine Estates' Earnings Growth And 3.1% ROE

It is quite clear that Treasury Wine Estates' ROE is rather low. Even when compared to the industry average of 12%, the ROE figure is pretty disappointing. For this reason, Treasury Wine Estates' five year net income decline of 10% is not surprising given its lower ROE. We believe that there also might be other aspects that are negatively influencing the company's earnings prospects. For instance, the company has a very high payout ratio, or is faced with competitive pressures.

So, as a next step, we compared Treasury Wine Estates' performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 12% over the last few years.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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 Treasury Wine Estates fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Treasury Wine Estates Efficiently Re-investing Its Profits?

With a high three-year median payout ratio of 100% (implying that -0.2% of the profits are retained), most of Treasury Wine Estates' profits are being paid to shareholders, which explains the company's shrinking earnings. With only a little being reinvested into the business, earnings growth would obviously be low or non-existent. Our risks dashboard should have the 2 risks we have identified for Treasury Wine Estates.

Moreover, Treasury Wine Estates 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. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 68% over the next three years. The fact that the company's ROE is expected to rise to 13% over the same period is explained by the drop in the payout ratio.

Conclusion

On the whole, Treasury Wine Estates' performance is quite a big let-down. The low ROE, combined with the fact that the company is paying out almost if not all, of its profits as dividends, has resulted in the lack or absence of growth in its earnings. 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. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page for the company.

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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.