Smartgroup’s (ASX:SIQ) stock is up by a considerable 14% over the past three months. Since the market usually pay for a company’s long-term fundamentals, we decided to study the company’s key performance indicators to see if they could be influencing the market. In this article, we decided to focus on Smartgroup’s 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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
How Is ROE Calculated?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders’ Equity
So, based on the above formula, the ROE for Smartgroup is:
22% = AU$61m ÷ AU$277m (Based on the trailing twelve months to December 2019).
The ‘return’ is the income the business earned over the last year. One way to conceptualize this is that for each A$1 of shareholders’ capital it has, the company made A$0.22 in profit.
Why Is ROE Important For 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. 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.
Smartgroup’s Earnings Growth And 22% ROE
To start with, Smartgroup’s ROE looks acceptable. Especially when compared to the industry average of 9.0% the company’s ROE looks pretty impressive. This certainly adds some context to Smartgroup’s exceptional 34% net income growth seen over the past five years. However, there could also be other causes behind this growth. For instance, the company has a low payout ratio or is being managed efficiently.
As a next step, we compared Smartgroup’s net income growth with the industry, and pleasingly, we found that the growth seen by the company is higher than the average industry growth of 23%.
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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is Smartgroup fairly valued compared to other companies? These 3 valuation measures might help you decide.
Is Smartgroup Efficiently Re-investing Its Profits?
The high three-year median payout ratio of 90% (implying that it keeps only 10% of profits) for Smartgroup suggests that the company’s growth wasn’t really hampered despite it returning most of the earnings to its shareholders.
Additionally, Smartgroup has paid dividends over a period of five years which means that the company is pretty serious about sharing its profits with shareholders. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 67% over the next three years. Despite the lower expected payout ratio, the company’s ROE is not expected to change by much.
Overall, we are quite pleased with Smartgroup’s performance. Especially the high ROE, Which has contributed to the impressive growth seen in earnings. Despite the company reinvesting only a small portion of its profits, it still has managed to grow its earnings so that is appreciable. Having said that, the company’s earnings growth is expected to slow down, as forecasted in the current analyst estimates. 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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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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