With its stock down 3.4% over the past month, it is easy to disregard Parex Resources (TSE:PXT). But if you pay close attention, you might gather that its strong financials could mean that the stock could potentially see an increase in value in the long-term, given how markets usually reward companies with good financial health. In this article, we decided to focus on Parex Resources' ROE.

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.

View our latest analysis for Parex Resources

How Do You 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 Parex Resources is:

31% = US$575m ÷ US$1.9b (Based on the trailing twelve months to September 2023).

The 'return' is the income the business earned over the last year. So, this means that for every CA$1 of its shareholder's investments, the company generates a profit of CA$0.31.

Why Is ROE Important For Earnings Growth?

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

Parex Resources' Earnings Growth And 31% ROE

Firstly, we acknowledge that Parex Resources has a significantly high ROE. Second, a comparison with the average ROE reported by the industry of 17% also doesn't go unnoticed by us. This probably laid the groundwork for Parex Resources' moderate 13% net income growth seen over the past five years.

Next, on comparing with the industry net income growth, we found that Parex Resources' reported growth was lower than the industry growth of 42% over the last few years, which is not something we like to see.

Earnings growth is a huge factor in stock valuation. 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 Parex Resources is trading on a high P/E or a low P/E, relative to its industry.

Is Parex Resources Efficiently Re-investing Its Profits?

In Parex Resources' case, its respectable earnings growth can probably be explained by its low three-year median payout ratio of 13% (or a retention ratio of 87%), which suggests that the company is investing most of its profits to grow its business.

Along with seeing a growth in earnings, Parex Resources only recently started paying dividends. Its quite possible that the company was looking to impress its shareholders. Our latest analyst data shows that the future payout ratio of the company is expected to rise to 24% over the next three years. Consequently, the higher expected payout ratio explains the decline in the company's expected ROE (to 20%) over the same period.

Conclusion

Overall, we are quite pleased with Parex Resources' performance. In particular, it's great to see that the company is investing heavily into its business and along with a high rate of return, that has resulted in a respectable growth in its earnings. 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. Let's not forget, business risk is also one of the factors that affects the price of the stock. So this is also an important area that investors need to pay attention to before making a decision on any business. To know the 2 risks we have identified for Parex Resources visit our risks dashboard for free.

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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.