Decline in stocks and decent financials: Is the market wrong on Eaton Corporation plc (NYSE:ETN)?

Eaton Inc (NYSE:ETN) had a difficult month with its share price down 9.4%. However, the company’s fundamentals look pretty decent and long-term financials are generally in line with future market price movements. In particular, we’ll be paying attention to Eaton’s ROE today.

Return on equity or ROE is a key metric used to gauge how effectively a company’s management is using the company’s capital. In short, ROE shows the profit that each dollar generates in relation to the investments of its shareholders.

See our latest analysis for Eaton

How to calculate return on equity?

The ROE formula is:

Return on equity = Net income (from continuing operations) ÷ Equity

So, based on the above formula, Eaton’s ROE is:

14% = US$2.3 billion ÷ US$16 billion (based on trailing 12 months to June 2022).

“Yield” refers to a company’s earnings over the past year. This therefore means that for each dollar of investment by its shareholder, the company generates a profit of $0.14.

What is the relationship between ROE and earnings growth?

So far we have learned that ROE is a measure of a company’s profitability. Based on the share of its profits that the company chooses to reinvest or “keep”, we are then able to assess a company’s future ability to generate profits. Assuming everything else remains unchanged, the higher the ROE and earnings retention, the higher a company’s growth rate relative to companies that don’t necessarily exhibit these characteristics.

Eaton’s earnings growth and ROE of 14%

For starters, Eaton’s ROE looks acceptable. Additionally, the company’s ROE is similar to the industry average of 12%. As you might expect, the 8.0% decline in net profit reported by Eaton comes as a bit of a surprise. We feel there could be other factors at play here that are preventing the company from growing. For example, the company pays a large portion of its profits in the form of dividends or faces competitive pressures.

That being said, we compared Eaton’s performance with that of the industry and became concerned when we found that while the company had cut profits, the industry had increased profits at a rate of 9, 4% over the same period.

Earnings growth is an important factor in stock valuation. The investor should try to establish whether the expected growth or decline in earnings, as the case may be, is taken into account. By doing so, he will get an idea if the title is heading for clear blue waters or if swampy waters await. Is the ETN correctly valued? This intrinsic business value infographic has everything you need to know.

Does Eaton effectively reinvest its profits?

Eaton’s has a high three-year median payout ratio of 57% (meaning it keeps 43% of its earnings). This suggests that the company pays out most of its profits in the form of dividends to its shareholders. This partly explains why his income has declined. The company has only a small pool of capital left to reinvest – A vicious cycle that does not benefit the company in the long term. Our risk dashboard should contain the 4 risks we have identified for Eaton.

Additionally, Eaton’s has paid dividends over a period of at least ten years, which means the company’s management is committed to paying dividends even if it means little or no earnings growth. After reviewing the latest analyst consensus data, we found that the company’s future payout ratio is expected to drop to 41% over the next three years. Thus, the expected decline in the payout rate explains the expected increase in the company’s ROE to 18%, over the same period.

Summary

All in all, it looks like Eaton has some positive aspects to its business. Still, the weak earnings growth is a bit of a concern, especially since the company has a high rate of return. Investors could have benefited from the high ROE had the company reinvested more of its earnings. As mentioned earlier, the company retains a small portion of its profits. That said, we have studied the latest analyst forecasts and found that although the company has decreased earnings in the past, analysts expect earnings to increase in the future. Are these analyst expectations based on general industry expectations or company fundamentals? Click here to access our analyst forecast page for the company.

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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.