It is hard to get excited after looking at Advanced Drainage Systems' (NYSE:WMS) recent performance, when its stock has declined 28% 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. In this article, we decided to focus on Advanced Drainage Systems' ROE.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

Check out our latest analysis for Advanced Drainage Systems

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 Advanced Drainage Systems is:

36% = US$496m ÷ US$1.4b (Based on the trailing twelve months to September 2024).

The 'return' is the yearly profit. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.36 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. 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. 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.

Advanced Drainage Systems' Earnings Growth And 36% ROE

To begin with, Advanced Drainage Systems has a pretty high ROE which is interesting. Secondly, even when compared to the industry average of 18% the company's ROE is quite impressive. Under the circumstances, Advanced Drainage Systems' considerable five year net income growth of 46% was to be expected.

As a next step, we compared Advanced Drainage Systems' net income growth with the industry, and pleasingly, we found that the growth seen by the company is higher than the average industry growth of 19%.

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. This then helps them determine if the stock is placed for a bright or bleak future. Is WMS fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is Advanced Drainage Systems Efficiently Re-investing Its Profits?

Advanced Drainage Systems' three-year median payout ratio to shareholders is 8.7%, which is quite low. This implies that the company is retaining 91% of its profits. So it looks like Advanced Drainage Systems is reinvesting profits heavily to grow its business, which shows in its earnings growth.

Besides, Advanced Drainage Systems has been paying dividends for at least ten years or more. This shows that the company is committed to sharing profits with its shareholders. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 10.0% of its profits over the next three years. Therefore, the company's future ROE is also not expected to change by much with analysts predicting an ROE of 32%.

Summary

Overall, we are quite pleased with Advanced Drainage Systems' performance. Specifically, we like that the company is reinvesting a huge chunk of its profits at a high rate of return. This of course has caused the company to see substantial growth in its earnings. That being so, a study of the latest analyst forecasts show that the company is expected to see a slowdown in its future earnings growth. 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.

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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.