Most readers would already be aware that Bharat Heavy Electricals’ (NSE:BHEL) stock increased significantly by 34% over the past three months. However, we wonder if the company’s inconsistent financials would have any adverse impact on the current share price momentum. In this article, we decided to focus on Bharat Heavy Electricals’ ROE.
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. In simpler terms, it measures the profitability of a company in relation to shareholder’s equity.
How To Calculate Return On Equity?
ROE 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 Bharat Heavy Electricals is:
2.7% = ₹7.0b ÷ ₹265b (Based on the trailing twelve months to June 2022).
The ‘return’ is the income the business earned over the last year. Another way to think of that is that for every ₹1 worth of equity, the company was able to earn ₹0.03 in profit.
What Has ROE Got To Do With 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. 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.
Bharat Heavy Electricals’ Earnings Growth And 2.7% ROE
As you can see, Bharat Heavy Electricals’ ROE looks pretty weak. Even when compared to the industry average of 10%, the ROE figure is pretty disappointing. For this reason, Bharat Heavy Electricals’ five year net income decline of 32% is not surprising given its lower ROE. We reckon that there could also be other factors at play here. Such as – low earnings retention or poor allocation of capital.
That being said, we compared Bharat Heavy Electricals’ 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 9.9% 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). Doing so will help them establish if the stock’s future looks promising or ominous. If you’re wondering about Bharat Heavy Electricals”s valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry
Is Bharat Heavy Electricals Making Efficient Use Of Its Profits?
In spite of a normal three-year median payout ratio of 31% (that is, a retention ratio of 69%), the fact that Bharat Heavy Electricals’ earnings have shrunk is quite puzzling. So there could be some other explanations in that regard. For instance, the company’s business may be deteriorating.
Additionally, Bharat Heavy Electricals 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. Our latest analyst data shows that the future payout ratio of the company is expected to rise to 40% over the next three years.
Conclusion
In total, we’re a bit ambivalent about Bharat Heavy Electricals’ performance. Even though it appears to be retaining most of its profits, given the low ROE, investors may not be benefitting from all that reinvestment after all. The low earnings growth suggests our theory correct. Wrapping up, we would proceed with caution with this company and one way of doing that would be to look at the risk profile of the business. You can see the 1 risk we have identified for Bharat Heavy Electricals by visiting our risks dashboard for free on our platform here.