Xylem's (NYSE:XYL) stock is up by 4.3% over the past month. As most would know, long-term fundamentals have a strong correlation with market price movements, so we decided to look at the company's key financial indicators today to determine if they have any role to play in the recent price movement. In this article, we decided to focus on Xylem's ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

See our latest analysis for Xylem

How Is ROE Calculated?

The formula for ROE is:

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

So, based on the above formula, the ROE for Xylem is:

7.8% = US$830m ÷ US$11b (Based on the trailing twelve months to September 2024).

The 'return' is the amount earned after tax over the last twelve months. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.08 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. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. 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.

Xylem's Earnings Growth And 7.8% ROE

When you first look at it, Xylem's ROE doesn't look that attractive. We then compared the company's ROE to the broader industry and were disappointed to see that the ROE is lower than the industry average of 15%. Although, we can see that Xylem saw a modest net income growth of 16% over the past five years. So, the growth in the company's earnings could probably have been caused by other variables. For instance, the company has a low payout ratio or is being managed efficiently.

Next, on comparing Xylem's net income growth with the industry, we found that the company's reported growth is similar to the industry average growth rate of 15% over the last few years.

Earnings growth is a huge factor in stock valuation. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. Doing so will help them establish if the stock's future looks promising or ominous. What is XYL worth today? The intrinsic value infographic in our free research report helps visualize whether XYL is currently mispriced by the market.

Is Xylem Efficiently Re-investing Its Profits?

Xylem has a healthy combination of a moderate three-year median payout ratio of 49% (or a retention ratio of 51%) and a respectable amount of growth in earnings as we saw above, meaning that the company has been making efficient use of its profits.

Additionally, Xylem has paid dividends over a period of at least ten years which means that the company is pretty serious about sharing its profits with shareholders. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 28% over the next three years. The fact that the company's ROE is expected to rise to 11% over the same period is explained by the drop in the payout ratio.

Summary

Overall, we feel that Xylem certainly does have some positive factors to consider. Despite its low rate of return, the fact that the company reinvests a very high portion of its profits into its business, no doubt contributed to its high earnings growth. On studying current analyst estimates, we found that analysts expect the company to continue its recent growth streak. 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.