Westlake Chemical (NYSE:WLK) has had a great run on the share market with its stock up by a significant 45% 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. Particularly, we will be paying attention to Westlake Chemical’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 short, ROE shows the profit each dollar generates with respect to its shareholder investments.

See our latest analysis for Westlake Chemical

How Is ROE Calculated?

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 Westlake Chemical is:

6.7% = US$432m ÷ US$6.4b (Based on the trailing twelve months to June 2020).

The ‘return’ refers to a company’s earnings over the last year. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.07 in profit.

What Is The Relationship Between ROE And Earnings Growth?

So far, we’ve learned that ROE is a measure of a company’s profitability. 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. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don’t share these attributes.

Westlake Chemical’s Earnings Growth And 6.7% ROE

At first glance, Westlake Chemical’s ROE doesn’t look very promising. We then compared the company’s ROE to the broader industry and were disappointed to see that the ROE is lower than the industry average of 10%. Accordingly, Westlake Chemical’s low net income growth of 2.5% over the past five years can possibly be explained by the low ROE amongst other factors.

As a next step, we compared Westlake Chemical’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 9.3% in the same period.

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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. 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 Westlake Chemical is trading on a high P/E or a low P/E, relative to its industry.

Is Westlake Chemical Efficiently Re-investing Its Profits?

A low three-year median payout ratio of 17% (implying that the company retains the remaining 83% of its income) suggests that Westlake Chemical is retaining most of its profits. This should be reflected in its earnings growth number, but that’s not the case. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.

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