It is hard to get excited after looking at Zurn Elkay Water Solutions' (NYSE:ZWS) recent performance, when its stock has declined 15% over the past three months. Given that stock prices are usually driven by a company's fundamentals over the long term, which in this case look pretty weak, we decided to study the company's key financial indicators. Specifically, we decided to study Zurn Elkay Water Solutions' 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. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

See our latest analysis for Zurn Elkay Water Solutions

How Do You 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 Zurn Elkay Water Solutions is:

3.1% = US$50m ÷ US$1.6b (Based on the trailing twelve months to September 2022).

The 'return' is the yearly profit. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.03 in profit.

What Has ROE Got To Do With Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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.

Zurn Elkay Water Solutions' Earnings Growth And 3.1% ROE

It is quite clear that Zurn Elkay Water Solutions' ROE is rather low. Even when compared to the industry average of 23%, the ROE figure is pretty disappointing. Therefore, it might not be wrong to say that the five year net income decline of 26% seen by Zurn Elkay Water Solutions was possibly a result of it having a lower ROE. However, there could also be other factors causing the earnings to decline. For instance, the company has a very high payout ratio, or is faced with competitive pressures.

However, when we compared Zurn Elkay Water Solutions' growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 13% in the same period. This is quite worrisome.

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. One good indicator of expected earnings growth is the P/E ratio which determines the price the market is willing to pay for a stock based on its earnings prospects. So, you may want to check if Zurn Elkay Water Solutions is trading on a high P/E or a low P/E, relative to its industry.

Is Zurn Elkay Water Solutions Making Efficient Use Of Its Profits?

Zurn Elkay Water Solutions has a high three-year median payout ratio of 61% (that is, it is retaining 39% 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. Our risks dashboard should have the 2 risks we have identified for Zurn Elkay Water Solutions.

Moreover, Zurn Elkay Water Solutions has been paying dividends for three years, which is a considerable amount of time, suggesting that management must have perceived that the shareholders prefer consistent dividends even though earnings have been shrinking. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 26% over the next three years.

Summary

Overall, we would be extremely cautious before making any decision on Zurn Elkay Water Solutions. 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. That being so, the latest industry analyst forecasts show that the analysts are expecting to see a huge improvement in the company's earnings growth rate. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page for the company.

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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.