Most readers would already know that Engenco's (ASX:EGN) stock increased by 1.7% over the past three months. However, its weak financial performance indicators makes us a bit doubtful if that trend could continue. Specifically, we decided to study Engenco's ROE in this article.

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.

View our latest analysis for Engenco

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 Engenco is:

6.8% = AU$6.4m ÷ AU$95m (Based on the trailing twelve months to June 2023).

The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each A$1 of shareholders' capital it has, the company made A$0.07 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 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 Engenco's Earnings Growth And 6.8% ROE

On the face of it, Engenco's ROE is not much to talk about. We then compared the company's ROE to the broader industry and were disappointed to see that the ROE is lower than the industry average of 8.7%. For this reason, Engenco's five year net income decline of 25% is not surprising given its 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.

However, when we compared Engenco's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 29% in the same period. This is quite worrisome.

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. This then helps them determine if the stock is placed for a bright or bleak future. Is Engenco fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Engenco Using Its Retained Earnings Effectively?

With a high three-year median payout ratio of 58% (implying that 42% of the profits are retained), most of Engenco's profits are being paid to shareholders, which explains the company's shrinking earnings. 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. You can see the 2 risks we have identified for Engenco by visiting our risks dashboard for free on our platform here.

In addition, Engenco has been paying dividends over a period of six years suggesting that keeping up dividend payments is preferred by the management even though earnings have been in decline.

Conclusion

In total, we would have a hard think before deciding on any investment action concerning Engenco. 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. So far, we've only made a quick discussion around the company's earnings growth. So it may be worth checking this free detailed graph of Engenco's past earnings, as well as revenue and cash flows to get a deeper insight into the company's performance.

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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.