With its stock down 14% over the past three months, it is easy to disregard Advanced Drainage Systems (NYSE:WMS). But if you pay close attention, you might gather that its strong financials could mean that the stock could potentially see an increase in value in the long-term, given how markets usually reward companies with good financial health. In this article, we decided to focus on Advanced Drainage Systems' ROE.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

How Do You 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 Advanced Drainage Systems is:

36% = US$496m ÷ US$1.4b (Based on the trailing twelve months to September 2024).

The 'return' is the amount earned after tax over the last twelve months. That means that for every $1 worth of shareholders' equity, the company generated $0.36 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 everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.

A Side By Side comparison of Advanced Drainage Systems' Earnings Growth And 36% ROE

First thing first, we like that Advanced Drainage Systems has an impressive ROE. Additionally, the company's ROE is higher compared to the industry average of 18% which is quite remarkable. So, the substantial 46% net income growth seen by Advanced Drainage Systems over the past five years isn't overly surprising.

Next, on comparing with the industry net income growth, we found that Advanced Drainage Systems' growth is quite high when compared to the industry average growth of 16% in the same period, which is great to see.

Earnings growth is a huge factor in stock valuation. It's important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. What is WMS worth today? The intrinsic value infographic in our free research report helps visualize whether WMS is currently mispriced by the market.

Is Advanced Drainage Systems Making Efficient Use Of Its Profits?

Advanced Drainage Systems' ' three-year median payout ratio is on the lower side at 8.7% implying that it is retaining a higher percentage (91%) of its profits. So it looks like Advanced Drainage Systems is reinvesting profits heavily to grow its business, which shows in its earnings growth.

Additionally, Advanced Drainage Systems has paid dividends over a period of at least ten years which means that the company is pretty serious about sharing its profits with shareholders. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 10.0% of its profits over the next three years. Accordingly, forecasts suggest that Advanced Drainage Systems' future ROE will be 32% which is again, similar to the current ROE.

Summary

In total, we are pretty happy with Advanced Drainage Systems' performance. Particularly, we like that the company is reinvesting heavily into its business, and at a high rate of return. Unsurprisingly, this has led to an impressive earnings growth. That being so, a study of the latest analyst forecasts show that the company is expected to see a slowdown in its future earnings growth. 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.