Most readers would already know that Smartgroup's (ASX:SIQ) stock increased by 4.5% over the past month. Given that stock prices are usually aligned with a company's financial performance in the long-term, we decided to investigate if the company's decent financials had a hand to play in the recent price move. In this article, we decided to focus on Smartgroup's ROE.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.
How To Calculate Return On Equity?
ROE 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 Smartgroup is:
18% = AU$48m ÷ AU$270m (Based on the trailing twelve months to June 2020).
The 'return' is the amount earned after tax over the last twelve months. That means that for every A$1 worth of shareholders' equity, the company generated A$0.18 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. 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.
A Side By Side comparison of Smartgroup's Earnings Growth And 18% ROE
To start with, Smartgroup's ROE looks acceptable. Even when compared to the industry average of 15% the company's ROE looks quite decent. Consequently, this likely laid the ground for the impressive net income growth of 24% seen over the past five years by Smartgroup. We believe that there might also be other aspects that are positively influencing the company's earnings 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 10%.
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. This then helps them determine if the stock is placed for a bright or bleak future. Is SIQ fairly valued? This infographic on the company's intrinsic value has everything you need to know.
Is Smartgroup Efficiently Re-investing Its Profits?
The high three-year median payout ratio of 90% (implying that it keeps only 9.8% of profits) for Smartgroup suggests that the company's growth wasn't really hampered despite it returning most of the earnings to its shareholders.
Moreover, Smartgroup is determined to keep sharing its profits with shareholders which we infer from its long history of six years of paying a dividend. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 67% over the next three years. As a result, the expected drop in Smartgroup's payout ratio explains the anticipated rise in the company's future ROE to 25%, over the same period.
Overall, we feel that Smartgroup certainly does have some positive factors to consider. Specifically, its high ROE which likely led to the growth in earnings. Bear in mind, the company reinvests little to none of its profits, which means that investors aren't necessarily reaping the full benefits of the high rate of return. 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. 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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