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Could Castings P.L.C.'s (LON:CGS) Weak Financials Mean That The Market Could Correct Its Share Price?

Simply Wall St


Most readers would already know that Castings' (LON:CGS) stock increased by 9.7% over the past three months. Given that the markets usually pay for the long-term financial health of a company, we wonder if the current momentum in the share price will keep up, given that the company's financials don't look very promising. Particularly, we will be paying attention to Castings' ROE today.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.


View our latest analysis for Castings

How Do You Calculate Return On Equity?

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 Castings is:

7.6% = UK£10m ÷ UK£132m (Based on the trailing twelve months to March 2020).

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 £0.08 in profit.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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. 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.

Castings' Earnings Growth And 7.6% ROE

When you first look at it, Castings' ROE doesn't look that attractive. A quick further study shows that the company's ROE doesn't compare favorably to the industry average of 17% either. Therefore, it might not be wrong to say that the five year net income decline of 8.7% seen by Castings was probably the 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. Such as - low earnings retention or poor allocation of capital.

That being said, we compared Castings' 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 30% in the same period.

past-earnings-growth
past-earnings-growth

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). This then helps them determine if the stock is placed for a bright or bleak future. If you're wondering about Castings''s valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Castings Efficiently Re-investing Its Profits?

With a high three-year median payout ratio of 58% (implying that 42% of the profits are retained), most of Castings' profits are being paid to shareholders, which explains the company's shrinking earnings. The business is only left with a small pool of capital to reinvest - A vicious cycle that doesn't benefit the company in the long-run.

In addition, Castings 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. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 40% over the next three years.

Summary

Overall, we would be extremely cautious before making any decision on Castings. Because the company is not reinvesting much into the business, and given the low ROE, it's not surprising to see the lack or absence of growth in its earnings. So far, we've only made a quick discussion around the company's earnings growth. To gain further insights into Castings' past profit growth, check out this visualization of past earnings, revenue and cash flows.

This article by Simply Wall St is general in nature. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com.