It is hard to get excited after looking at Contact Energy's (NZSE:CEN) recent performance, when its stock has declined 5.2% over the past three months. To decide if this trend could continue, we decided to look at its weak fundamentals as they shape the long-term market trends. Particularly, we will be paying attention to Contact Energy'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.

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How Is ROE Calculated?

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 Contact Energy is:

8.5% = NZ$224m ÷ NZ$2.6b (Based on the trailing twelve months to December 2024).

The 'return' is the yearly profit. That means that for every NZ$1 worth of shareholders' equity, the company generated NZ$0.08 in profit.

View our latest analysis for Contact Energy

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. 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 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 Contact Energy's Earnings Growth And 8.5% ROE

On the face of it, Contact Energy's ROE is not much to talk about. Yet, a closer study shows that the company's ROE is similar to the industry average of 8.5%. On the other hand, Contact Energy reported a moderate 9.5% net income growth over the past five years. Taking into consideration that the ROE is not particularly high, we reckon that there could also be other factors at play which could be influencing the company's growth. For example, it is possible that the company's management has made some good strategic decisions, or that the company has a low payout ratio.

As a next step, we compared Contact Energy's net income growth with the industry and were disappointed to see that the company's growth is lower than the industry average growth of 20% in the same period.

Earnings growth is an important metric to consider when valuing a stock. 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. One good indicator of expected earnings growth is the P/E ratio which determines the price the market is willing to pay for a stock based on its earnings prospects. So, you may want to check if Contact Energy is trading on a high P/E or a low P/E , relative to its industry.

Is Contact Energy Using Its Retained Earnings Effectively?

Contact Energy's high three-year median payout ratio of 135% suggests that the company is paying out more to its shareholders than what it is making. In spite of this, the company was able to grow its earnings respectably, as we saw above. Although, the high payout ratio is certainly something we would keep an eye on if the company is not able to keep up its growth, or if business deteriorates. Our risks dashboard should have the 3 risks we have identified for Contact Energy.

Moreover, Contact Energy is determined to keep sharing its profits with shareholders which we infer from its long history of paying a dividend for at least ten years. Based on the latest analysts' estimates, we found that the company's future payout ratio over the next three years is expected to hold steady at 109%. Regardless, the future ROE for Contact Energy is predicted to rise to 13% despite there being not much change expected in its payout ratio.

Conclusion

Overall, we would be extremely cautious before making any decision on Contact Energy. Although the company has shown a fair bit of growth in earnings, yet the low ROE and the low rate of reinvestment makes us skeptical about the continuity of that growth, especially when or if the business comes to face any threats. On studying current analyst estimates, we found that analysts expect the company to continue its recent growth streak. 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.