Can Flowserve Corporation's (NYSE:FLS) Weak Financials Pull The Plug On The Stock's Current Momentum On Its Share Price?
Flowserve (NYSE:FLS) has had a great run on the share market with its stock up by a significant 31% over the last three months. However, we decided to pay close attention to its weak financials as we are doubtful that the current momentum will keep up, given the scenario. Specifically, we decided to study Flowserve's 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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
View our latest analysis for Flowserve
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 Flowserve is:
9.1% = US$155m ÷ US$1.7b (Based on the trailing twelve months to September 2020).
The 'return' is the yearly profit. That means that for every $1 worth of shareholders' equity, the company generated $0.09 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. 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.
Flowserve's Earnings Growth And 9.1% ROE
When you first look at it, Flowserve's ROE doesn't look that attractive. However, its ROE is similar to the industry average of 11%, so we won't completely dismiss the company. But Flowserve saw a five year net income decline of 9.6% over the past five years. Remember, the company's ROE is a bit low to begin with. Therefore, the decline in earnings could also be the result of this.
That being said, we compared Flowserve'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 9.1% in the same period.
Earnings growth is a huge factor in stock valuation. 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. Has the market priced in the future outlook for FLS? You can find out in our latest intrinsic value infographic research report.
Is Flowserve Using Its Retained Earnings Effectively?
Flowserve has a high three-year median payout ratio of 52% (that is, it is retaining 48% of its profits). This suggests that the company is paying most of its profits as dividends to its shareholders. This goes some way in explaining why its earnings have been shrinking. 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. To know the 3 risks we have identified for Flowserve visit our risks dashboard for free.
Moreover, Flowserve has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over earnings growth. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 35% over the next three years. As a result, the expected drop in Flowserve's payout ratio explains the anticipated rise in the company's future ROE to 13%, over the same period.
Conclusion
In total, we would have a hard think before deciding on any investment action concerning Flowserve. 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. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. 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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