Zurn Elkay Water Solutions' (NYSE:ZWS) stock is up by 3.4% over the past week. However, the company's financials look a bit inconsistent and market outcomes are ultimately driven by long-term fundamentals, meaning that the stock could head in either direction. In this article, we decided to focus on Zurn Elkay Water Solutions' 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. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

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 Zurn Elkay Water Solutions is:

8.0% = US$128m ÷ US$1.6b (Based on the trailing twelve months to June 2024).

The 'return' is the income the business earned over the last year. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.08 in profit.

What Is The Relationship Between ROE And Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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. Assuming all else is equal, companies that have both a higher return on equity and higher profit retention are usually the ones that have a higher growth rate when compared to companies that don't have the same features.

Zurn Elkay Water Solutions' Earnings Growth And 8.0% ROE

When you first look at it, Zurn Elkay Water Solutions' ROE doesn't look that attractive. A quick further study shows that the company's ROE doesn't compare favorably to the industry average of 19% either. For this reason, Zurn Elkay Water Solutions' five year net income decline of 12% is not surprising given its lower ROE. However, there could also be other factors causing the earnings to decline. Such as - low earnings retention or poor allocation of capital.

However, when we compared Zurn Elkay Water Solutions' growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 18% in the same period. This is quite worrisome.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. This then helps them determine if the stock is placed for a bright or bleak future. Is ZWS fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is Zurn Elkay Water Solutions Using Its Retained Earnings Effectively?

Looking at its three-year median payout ratio of 49% (or a retention ratio of 51%) which is pretty normal, Zurn Elkay Water Solutions' declining earnings is rather baffling as one would expect to see a fair bit of growth when a company is retaining a good portion of its profits. So there could be some other explanations in that regard. For instance, the company's business may be deteriorating.

Additionally, Zurn Elkay Water Solutions has paid dividends over a period of five 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 22% over the next three years. The fact that the company's ROE is expected to rise to 13% over the same period is explained by the drop in the payout ratio.

Conclusion

Overall, we have mixed feelings about Zurn Elkay Water Solutions. While the company does have a high rate of profit retention, its low rate of return is probably hampering its earnings growth. That being so, the latest industry analyst forecasts show that the analysts are expecting to see a huge improvement in the company's earnings growth rate. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page 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.