Are Phillips 66's (NYSE:PSX) Fundamentals Good Enough to Warrant Buying Given The Stock's Recent Weakness?

It is hard to get excited after looking at Phillips 66's (NYSE:PSX) recent performance, when its stock has declined 4.7% over the past month. But if you pay close attention, you might find that its key financial indicators look quite decent, which could mean that the stock could potentially rise in the long-term given how markets usually reward more resilient long-term fundamentals. In this article, we decided to focus on Phillips 66's ROE.

 

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

 

Check out our latest analysis for Phillips 66

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How Is ROE Calculated?

The formula for ROE is:

 

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

 

So, based on the above formula, the ROE for Phillips 66 is:

 

33% = US$11b ÷ US$34b (Based on the trailing twelve months to December 2022).

 

The 'return' is the yearly profit. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.33 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.

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Phillips 66's Earnings Growth And 33% ROE

First thing first, we like that Phillips 66 has an impressive ROE. Additionally, a comparison with the average industry ROE of 31% also portrays the company's ROE in a good light. However, while Phillips 66 has a pretty respectable ROE, its five year net income decline rate was 5.5%. We reckon that there could be some other factors at play here that are preventing the company's growth. Such as, the company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.

 

So, as a next step, we compared Phillips 66's performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 13% in the same period.

 

Earnings growth is an important metric to consider when valuing a stock. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. Doing so will help them establish if the stock's future looks promising or ominous. Is PSX fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is Phillips 66 Using Its Retained Earnings Effectively?

Phillips 66's low three-year median payout ratio of 16% (implying that it retains the remaining 84% of its profits) comes as a surprise when you pair it with the shrinking earnings. This typically shouldn't be the case when a company is retaining most of its earnings. So there might be other factors at play here which could potentially be hampering growth. For instance, the business has faced some headwinds.

 

Additionally, Phillips 66 has paid dividends over a period of at least ten years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to rise to 43% over the next three years. Accordingly, the expected increase in the payout ratio explains the expected decline in the company's ROE to 13%, over the same period.

 

Conclusion

In total, it does look like Phillips 66 has some positive aspects to its business. However, given the high ROE and high profit retention, we would expect the company to be delivering strong earnings growth, but that isn't the case here. This suggests that there might be some external threat to the business, that's hampering its growth. Moreover, after studying current analyst estimates, we discovered that the company's earnings are expected to continue to shrink in the future. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.

 

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