Zurn Elkay Water Solutions (NYSE:ZWS) has had a great run on the share market with its stock up by a significant 18% over the last three months. However, we wonder if the company's inconsistent financials would have any adverse impact on the current share price momentum. 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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.

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:

8.6% = US$136m ÷ US$1.6b (Based on the trailing twelve months to September 2024).

The 'return' is the amount earned after tax over the last twelve months. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.09 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. 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 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 8.6% ROE

On the face of it, Zurn Elkay Water Solutions' ROE is not much to talk about. Next, when compared to the average industry ROE of 18%, the company's ROE leaves us feeling even less enthusiastic. Given the circumstances, the significant decline in net income by 3.7% seen by Zurn Elkay Water Solutions over the last five years is not surprising. However, there could also be other factors causing the earnings to decline. For example, it is possible that the business has allocated capital poorly or that the company has a very high payout ratio.

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 16% in the same period. This is quite worrisome.

Earnings growth is a huge factor in stock valuation. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. 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 Efficiently Re-investing Its Profits?

In spite of a normal three-year median payout ratio of 48% (that is, a retention ratio of 52%), the fact that Zurn Elkay Water Solutions' earnings have shrunk is quite puzzling. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.

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 23% over the next three years. As a result, the expected drop in Zurn Elkay Water Solutions' payout ratio explains the anticipated rise in the company's future ROE to 13%, over the same period.

Conclusion

On the whole, we feel that the performance shown by Zurn Elkay Water Solutions can be open to many interpretations. While the company does have a high rate of reinvestment, the low ROE means that all that reinvestment is not reaping any benefit to its investors, and moreover, its having a negative impact on the earnings growth. 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. 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.