Does Tower Limited's (NZSE:TWR) Weak Fundamentals Mean That The Market Could Correct Its Share Price?

editorial-team@simplywallst.com (Simply Wall St)

Mon, Aug 19, 2024, 3:23 PM 4 min read

Tower (NZSE:TWR) has had a great run on the share market with its stock up by a significant 41% over the last three months. However, in this article, we decided to focus on its weak fundamentals, as long-term financial performance of a business is what ultimately dictates market outcomes. Particularly, we will be paying attention to Tower's ROE today.

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

Check out our latest analysis for Tower

How To Calculate Return On Equity?

The formula for ROE is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Tower is:

10% = NZ$35m ÷ NZ$334m (Based on the trailing twelve months to March 2024).

The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each NZ$1 of shareholders' capital it has, the company made NZ$0.10 in profit.

What Has ROE Got To Do With Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. 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.

Tower's Earnings Growth And 10% ROE

When you first look at it, Tower's ROE doesn't look that attractive. However, given that the company's ROE is similar to the average industry ROE of 11%, we may spare it some thought. We can see that Tower has grown at a five year net income growth average rate of 2.9%, which is a bit on the lower side. Remember, the company's ROE is not particularly great to begin with. Hence, this does provide some context to low earnings growth seen by the company.

As a next step, we compared Tower's net income growth with the industry and were disappointed to see that the company's growth is lower than the industry average growth of 11% in the same period.

past-earnings-growth — NZSE:TWR Past Earnings Growth August 19th 2024

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). Doing so will help them establish if the stock's future looks promising or ominous. One good indicator of expected earnings growth is the P/E ratio which determines the price the market is willing to pay for a stock based on its earnings prospects. So, you may want to check if Tower is trading on a high P/E or a low P/E, relative to its industry.

Is Tower Efficiently Re-investing Its Profits?

Tower has a very high three-year median payout ratio of 125%, which suggests that the company is dipping into more than just its profits to pay its dividend and that shows in its low earnings growth number. This is indicative of risk.

In addition, Tower has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 55% over the next three years. The fact that the company's ROE is expected to rise to 18% over the same period is explained by the drop in the payout ratio.

Conclusion

On the whole, Tower's performance is quite a big let-down. The low ROE, combined with the fact that the company is paying out almost if not all, of its profits as dividends, has resulted in the lack or absence of growth in its earnings. With that said, the latest industry analyst forecasts reveal that the company's earnings are expected to accelerate. 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.