Waterco Limited's (ASX:WAT) Fundamentals Look Pretty Strong: Could The Market Be Wrong About The Stock?

It is hard to get excited after looking at Waterco's (ASX:WAT) recent performance, when its stock has declined 2.2% over the past month. However, stock prices are usually driven by a company’s financial performance over the long term, which in this case looks quite promising. Particularly, we will be paying attention to Waterco'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. Put another way, it reveals the company's success at turning shareholder investments into profits.

Check out our latest analysis for Waterco

How To Calculate Return On Equity?

Return on equity can be calculated by using the formula:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Waterco is:

10% = AU$12m ÷ AU$111m (Based on the trailing twelve months to June 2022).

The 'return' is the amount earned after tax over the last twelve months. So, this means that for every A$1 of its shareholder's investments, the company generates a profit of A$0.10.

What Has ROE Got To Do With Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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 Waterco's Earnings Growth And 10% ROE

To start with, Waterco's ROE looks acceptable. Yet, the fact that the company's ROE is lower than the industry average of 13% does temper our expectations. Still, we can see that Waterco has seen a remarkable net income growth of 27% over the past five years. Therefore, there could be other causes behind this growth. For instance, the company has a low payout ratio or is being managed efficiently. Bear in mind, the company does have a respectable ROE. It is just that the industry ROE is higher. So this also does lend some color to the high earnings growth seen by the company.

As a next step, we compared Waterco's net income growth with the industry, and pleasingly, we found that the growth seen by the company is higher than the average industry growth of 21%.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. Doing so will help them establish if the stock's future looks promising or ominous. Is Waterco fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Waterco Efficiently Re-investing Its Profits?

Waterco's three-year median payout ratio is a pretty moderate 30%, meaning the company retains 70% of its income. By the looks of it, the dividend is well covered and Waterco is reinvesting its profits efficiently as evidenced by its exceptional growth which we discussed above.

Additionally, Waterco has paid dividends over a period of at least ten years which means that the company is pretty serious about sharing its profits with shareholders.

Conclusion

On the whole, we feel that Waterco's performance has been quite good. Specifically, we like that it has been reinvesting a high portion of its profits at a moderate rate of return, resulting in earnings expansion. If the company continues to grow its earnings the way it has, that could have a positive impact on its share price given how earnings per share influence long-term share prices. Not to forget, share price outcomes are also dependent on the potential risks a company may face. So it is important for investors to be aware of the risks involved in the business. You can see the 2 risks we have identified for Waterco by visiting our risks dashboard for free on our platform here.

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

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.

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