With its stock down 4.0% over the past three months, it is easy to disregard Otter Tail (NASDAQ:OTTR). However, stock prices are usually driven by a company's financial performance over the long term, which in this case looks quite promising. Specifically, we decided to study Otter Tail's ROE in this article.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

How To 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 Otter Tail is:

20% = US$294m ÷ US$1.4b (Based on the trailing twelve months to December 2023).

The 'return' refers to a company's earnings over the last year. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.20 in profit.

What Has ROE Got To Do With Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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.

Otter Tail's Earnings Growth And 20% ROE

To start with, Otter Tail's ROE looks acceptable. Especially when compared to the industry average of 9.0% the company's ROE looks pretty impressive. Probably as a result of this, Otter Tail was able to see an impressive net income growth of 32% over the last five years. We believe that there might also be other aspects that are positively influencing the company's earnings growth. For instance, the company has a low payout ratio or is being managed efficiently.

We then compared Otter Tail's net income growth with the industry and we're pleased to see that the company's growth figure is higher when compared with the industry which has a growth rate of 5.4% in the same 5-year period.

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). By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. If you're wondering about Otter Tail's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Otter Tail Efficiently Re-investing Its Profits?

Otter Tail has a three-year median payout ratio of 26% (where it is retaining 74% of its income) which is not too low or not too high. So it seems that Otter Tail is reinvesting efficiently in a way that it sees impressive growth in its earnings (discussed above) and pays a dividend that's well covered.

Moreover, Otter Tail is determined to keep sharing its profits with shareholders which we infer from its long history of paying a dividend for at least ten years. Looking at the current analyst consensus data, we can see that the company's future payout ratio is expected to rise to 54% over the next three years. Consequently, the higher expected payout ratio explains the decline in the company's expected ROE (to 12%) over the same period.

Conclusion

Overall, we are quite pleased with Otter Tail's performance. Particularly, we like that the company is reinvesting heavily into its business, and at a high rate of return. Unsurprisingly, this has led to an impressive earnings growth. That being so, according to the latest industry analyst forecasts, the company's earnings are expected to shrink in the future. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.

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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.