TransAlta's (TSE:TA) stock up by 3.3% over the past month. 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. In this article, we decided to focus on TransAlta's ROE.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.
How To 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 TransAlta is:
4.7% = CA$189m ÷ CA$4.0b (Based on the trailing twelve months to June 2020).
The 'return' is the income the business earned over the last year. Another way to think of that is that for every CA$1 worth of equity, the company was able to earn CA$0.05 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. 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.
TransAlta's Earnings Growth And 4.7% ROE
When you first look at it, TransAlta's ROE doesn't look that attractive. Next, when compared to the average industry ROE of 6.9%, the company's ROE leaves us feeling even less enthusiastic. Therefore, it might not be wrong to say that the five year net income decline of 30% seen by TransAlta was probably the result of it having a lower ROE. However, there could also be other factors causing the earnings to decline. For example, it is possible that the business has allocated capital poorly or that the company has a very high payout ratio.
That being said, we compared TransAlta'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 33% in the same period.
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. Is TransAlta fairly valued compared to other companies? These 3 valuation measures might help you decide.
Is TransAlta Making Efficient Use Of Its Profits?
TransAlta's declining earnings is not surprising given how the company is spending most of its profits in paying dividends, judging by its LTM (or last twelve month) payout ratio of 55% (or a retention ratio of 45%). 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. Our risks dashboard should have the 3 risks we have identified for TransAlta.
Additionally, TransAlta has paid dividends over a period of at least ten years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth.
In total, we would have a hard think before deciding on any investment action concerning TransAlta. The company has seen a lack of earnings growth as a result of retaining very little profits and whatever little it does retain, is being reinvested at a very low rate of return. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.
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.
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