Should Weakness in Select Harvests Limited's (ASX:SHV) Stock Be Seen As A Sign That Market Will Correct The Share Price Given Decent Financials?

Select Harvests (ASX:SHV) has had a rough three months with its share price down 6.7%. However, the company's fundamentals look pretty decent, and long-term financials are usually aligned with future market price movements. Specifically, we decided to study Select Harvests' ROE in this article.

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.

View our latest analysis for Select Harvests

How To Calculate Return On Equity?

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 Select Harvests is:

13% = AU$50m ÷ AU$392m (Based on the trailing twelve months to March 2020).

The 'return' is the yearly profit. Another way to think of that is that for every A$1 worth of equity, the company was able to earn A$0.13 in profit.

What Has ROE Got To Do With Earnings Growth?

So far, we've learnt that ROE is a measure of a company's profitability. Depending on how much of these profits the company reinvests or "retains", and how effectively it does so, we are then able to assess a company’s earnings growth potential. 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.

Select Harvests' Earnings Growth And 13% ROE

To start with, Select Harvests' ROE looks acceptable. Further, the company's ROE compares quite favorably to the industry average of 4.8%. For this reason, Select Harvests' five year net income decline of 9.2% raises the question as to why the high ROE didn't translate into earnings growth. Based on this, we feel that there might be other reasons which haven't been discussed so far in this article that could be hampering the company's growth. These include low earnings retention or poor allocation of capital.

Furthermore, even when compared to the industry, which has been shrinking its earnings at a rate 2.2% in the same period, we found that Select Harvests' performance is pretty disappointing, as it suggests that the company has been shrunk its earnings at a rate faster than the industry.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. This then helps them determine if the stock is placed for a bright or bleak future. Is SHV fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is Select Harvests Making Efficient Use Of Its Profits?

Select Harvests' declining earnings is not surprising given how the company is spending most of its profits in paying dividends, judging by its three-year median payout ratio of 58% (or a retention ratio of 42%). With only a little being reinvested into the business, earnings growth would obviously be low or non-existent.

Additionally, Select Harvests 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. Based on the latest analysts' estimates, we found that the company's future payout ratio over the next three years is expected to hold steady at 55%. Accordingly, forecasts suggest that Select Harvests' future ROE will be 11% which is again, similar to the current ROE.

Summary

On the whole, we do feel that Select Harvests has some positive attributes. However, while the company does have a high ROE, its earnings growth number is quite disappointing. This can be blamed on the fact that it reinvests only a small portion of its profits and pays out the rest as dividends. That being so, the latest industry analyst forecasts show that the analysts are expecting to see a huge improvement in the company's earnings growth rate. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.

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This article by Simply Wall St is general in nature. 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.
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