Most readers would already know that Zurn Elkay Water Solutions' (NYSE:ZWS) stock increased by 2.7% over the past three months. Given that the markets usually pay for the long-term financial health of a company, we wonder if the current momentum in the share price will keep up, given that the company's financials don't look very promising. Particularly, we will be paying attention to Zurn Elkay Water Solutions' ROE today.

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. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

How Is ROE Calculated?

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 Zurn Elkay Water Solutions is:

7.2% = US$116m ÷ US$1.6b (Based on the trailing twelve months to March 2024).

The 'return' is the yearly profit. That means that for every $1 worth of shareholders' equity, the company generated $0.07 in profit.

What Is The Relationship Between ROE And 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.

A Side By Side comparison of Zurn Elkay Water Solutions' Earnings Growth And 7.2% ROE

At first glance, Zurn Elkay Water Solutions' 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. Therefore, it might not be wrong to say that the five year net income decline of 19% seen by Zurn Elkay Water Solutions was probably the result of it having a lower ROE. We reckon that there could also be other factors at play here. Such as - low earnings retention or poor allocation of capital.

So, as a next step, we compared Zurn Elkay Water Solutions' performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 14% over the last few years.

Earnings growth is an important metric to consider when valuing a stock. 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. What is ZWS worth today? The intrinsic value infographic in our free research report helps visualize whether ZWS is currently mispriced by the market.

Is Zurn Elkay Water Solutions Using Its Retained Earnings Effectively?

Zurn Elkay Water Solutions has a high three-year median payout ratio of 53% (that is, it is retaining 47% 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. With only very little left to reinvest into the business, growth in earnings is far from likely.

Additionally, Zurn Elkay Water Solutions has paid dividends over a period of four years, which means that the company's management is rather focused on keeping up its dividend payments, regardless of the shrinking earnings. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 24% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 12%, over the same period.

Conclusion

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. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts 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.