With its stock down 23% over the past month, it is easy to disregard East West Petroleum (CVE:EW). However, the company's fundamentals look pretty decent, and long-term financials are usually aligned with future market price movements. In this article, we decided to focus on East West Petroleum's 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 other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

View our latest analysis for East West Petroleum

How To Calculate Return On Equity?

The formula for ROE is:

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

So, based on the above formula, the ROE for East West Petroleum is:

6.2% = CA$300k ÷ CA$4.8m (Based on the trailing twelve months to September 2023).

The 'return' is the amount earned after tax over the last twelve months. That means that for every CA$1 worth of shareholders' equity, the company generated CA$0.06 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.

A Side By Side comparison of East West Petroleum's Earnings Growth And 6.2% ROE

At first glance, East West Petroleum's ROE doesn't look very promising. A quick further study shows that the company's ROE doesn't compare favorably to the industry average of 17% either. East West Petroleum was still able to see a decent net income growth of 15% over the past five years. We reckon that there could be other factors at play here. Such as - high earnings retention or an efficient management in place.

As a next step, we compared East West Petroleum's net income growth with the industry and were disappointed to see that the company's growth is lower than the industry average growth of 42% in the same period.

Earnings growth is an important metric to consider when valuing a stock. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. 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 East West Petroleum is trading on a high P/E or a low P/E, relative to its industry.

Is East West Petroleum Using Its Retained Earnings Effectively?

East West Petroleum doesn't pay any dividend currently which essentially means that it has been reinvesting all of its profits into the business. This definitely contributes to the decent earnings growth number that we discussed above.

Conclusion

Overall, we feel that East West Petroleum certainly does have some positive factors to consider. That is, a decent growth in earnings backed by a high rate of reinvestment. However, we do feel that that earnings growth could have been higher if the business were to improve on the low ROE rate. Especially given how the company is reinvesting a huge chunk of its profits. While we won't completely dismiss the company, what we would do, is try to ascertain how risky the business is to make a more informed decision around the company. Our risks dashboard would have the 3 risks we have identified for East West Petroleum.

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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.