Downer EDI (ASX:DOW) has had a rough three months with its share price down 9.3%. We decided to study the company's financials to determine if the downtrend will continue as the long-term performance of a company usually dictates market outcomes. In this article, we decided to focus on Downer EDI's ROE.

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. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

Check out our latest analysis for Downer EDI

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 Downer EDI is:

3.8% = AU$86m ÷ AU$2.2b (Based on the trailing twelve months to December 2024).

The 'return' is the amount earned after tax over the last twelve months. One way to conceptualize this is that for each A$1 of shareholders' capital it has, the company made A$0.04 in profit.

Why Is ROE Important For 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.

Downer EDI's Earnings Growth And 3.8% ROE

It is quite clear that Downer EDI's ROE is rather low. Even compared to the average industry ROE of 13%, the company's ROE is quite dismal. Therefore, it might not be wrong to say that the five year net income decline of 20% seen by Downer EDI was possibly a result of it having a lower ROE. We believe that there also might be other aspects that are negatively influencing the company's earnings prospects. For example, the business has allocated capital poorly, or that the company has a very high payout ratio.

That being said, we compared Downer EDI's performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 15% in the same 5-year period.

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 DOW worth today? The intrinsic value infographic in our free research report helps visualize whether DOW is currently mispriced by the market.

Is Downer EDI Using Its Retained Earnings Effectively?

Downer EDI's declining earnings is not surprising given how the company is spending most of its profits in paying dividends, judging by its three-year median payout ratio of 100% (or a retention ratio of -0.2%). With only very little left to reinvest into the business, growth in earnings is far from likely. You can see the 2 risks we have identified for Downer EDI by visiting our risks dashboard for free on our platform here.

In addition, Downer EDI has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 62% over the next three years. The fact that the company's ROE is expected to rise to 15% over the same period is explained by the drop in the payout ratio.

Summary

In total, we would have a hard think before deciding on any investment action concerning Downer EDI. Specifically, it has shown quite an unsatisfactory performance as far as earnings growth is concerned, and a poor ROE and an equally poor rate of reinvestment seem to be the reason behind this inadequate performance. 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.