New Energy Solar (ASX:NEW) has had a great run on the share market with its stock up by a significant 14% over the last three months. However, in this article, we decided to focus on its weak fundamentals, as long-term financial performance of a business is what ultimatley dictates market outcomes. Particularly, we will be paying attention to New Energy Solar's ROE today.

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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

Check out our latest analysis for New Energy Solar

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 New Energy Solar is:

1.3% = AU$4.6m ÷ AU$361m (Based on the trailing twelve months to June 2022).

The 'return' is the profit over the last twelve months. One way to conceptualize this is that for each A$1 of shareholders' capital it has, the company made A$0.01 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. 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. 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.

New Energy Solar's Earnings Growth And 1.3% ROE

It is hard to argue that New Energy Solar's ROE is much good in and of itself. Not just that, even compared to the industry average of 9.5%, the company's ROE is entirely unremarkable. For this reason, New Energy Solar's five year net income decline of 45% is not surprising given its 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.

As a next step, we compared New Energy Solar's performance with the industry and found thatNew Energy Solar's performance is depressing even when compared with the industry, which has shrunk its earnings at a rate of 36% in the same period, which is a slower than the company.

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 New Energy Solar is trading on a high P/E or a low P/E, relative to its industry.

Is New Energy Solar Using Its Retained Earnings Effectively?

With a LTM (or last twelve month) payout ratio as high as 326%,New Energy Solar's shrinking earnings don't come as a surprise as the company is paying a dividend which is beyond its means. Paying a dividend higher than reported profits is not a sustainable move. Our risks dashboard should have the 2 risks we have identified for New Energy Solar.

Moreover, New Energy Solar has been paying dividends for five 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.

Conclusion

Overall, we would be extremely cautious before making any decision on New Energy Solar. The low ROE, combined with the fact that the company is paying out almost if not all, of its profits as dividends, has resulted in the lack or absence of growth in its earnings. Up till now, we've only made a short study of the company's growth data. So it may be worth checking this free detailed graph of New Energy Solar's past earnings, as well as revenue and cash flows to get a deeper insight into the company's performance.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.

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