With its stock down 3.7% over the past month, it is easy to disregard Advanced Drainage Systems (NYSE:WMS). However, stock prices are usually driven by a company’s financials over the long term, which in this case look pretty respectable. Specifically, we decided to study Advanced Drainage Systems' ROE in this article.
Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. Put another way, it reveals the company's success at turning shareholder investments into profits.
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 Advanced Drainage Systems is:
21% = US$226m ÷ US$1.1b (Based on the trailing twelve months to March 2021).
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 $0.21 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. 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.
A Side By Side comparison of Advanced Drainage Systems' Earnings Growth And 21% ROE
To begin with, Advanced Drainage Systems seems to have a respectable ROE. Especially when compared to the industry average of 16% the company's ROE looks pretty impressive. Given the circumstances, we can't help but wonder why Advanced Drainage Systems saw little to no growth in the past five years. Therefore, there could be some other aspects that could potentially be preventing the company from growing. Such as, the company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.
We then compared Advanced Drainage Systems' net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 4.8% in the same period, which is a bit concerning.
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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Has the market priced in the future outlook for WMS? You can find out in our latest intrinsic value infographic research report.
Is Advanced Drainage Systems Efficiently Re-investing Its Profits?
Advanced Drainage Systems' low three-year median payout ratio of 17%, (meaning the company retains83% of profits) should mean that the company is retaining most of its earnings and consequently, should see higher growth than it has reported.
Additionally, Advanced Drainage Systems has paid dividends over a period of seven years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 9.2% over the next three years. However, the company's ROE is not expected to change by much despite the lower expected payout ratio.
On the whole, we do feel that Advanced Drainage Systems has some positive attributes. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE and and a high reinvestment rate. We believe that there might be some outside factors that could be having a negative impact on the business. Having said that, looking at the current analyst estimates, we found that the company's earnings are expected to gain momentum. 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.
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 (at) simplywallst.com.