Are SDI Limited's (ASX:SDI) Fundamentals Good Enough to Warrant Buying Given The Stock's Recent Weakness?

SDI (ASX:SDI) has had a rough month with its share price down 7.8%. However, stock prices are usually driven by a company’s financials over the long term, which in this case look pretty respectable. Particularly, we will be paying attention to SDI's ROE today.

ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

Check out our latest analysis for SDI

How Do You 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 SDI is:

10% = AU$7.7m ÷ AU$75m (Based on the trailing twelve months to December 2019).

The 'return' refers to a company's earnings over the last year. So, this means that for every A$1 of its shareholder's investments, the company generates a profit of A$0.10.

Why Is ROE Important For 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. 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.

SDI's Earnings Growth And 10% ROE

To begin with, SDI seems to have a respectable ROE. Even when compared to the industry average of 10% the company's ROE looks quite decent. SDI's decent returns aren't reflected in SDI'smediocre five year net income growth average of 2.1%. So, there could be some other factors at play that could be impacting the company's growth. For instance, the company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.

Next, on comparing with the industry net income growth, we found that SDI's reported growth was lower than the industry growth of 12% in the same period, which is not something we like to see.

Earnings growth is a huge factor in stock valuation. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. Doing so will help them establish if the stock's future looks promising or ominous. Is SDI fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is SDI Using Its Retained Earnings Effectively?

Despite having a normal three-year median payout ratio of 44% (or a retention ratio of 56% over the past three years, SDI has seen very little growth in earnings as we saw above. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.

In addition, SDI has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth.

Conclusion

On the whole, we do feel that SDI has some positive attributes. Yet, the low earnings growth is a bit concerning, especially given that the company has a high rate of return and is reinvesting ma huge portion of its profits. By the looks of it, there could be some other factors, not necessarily in control of the business, that's preventing growth. While we won't completely dismiss the company, what we would do, is try to ascertain how risky the business is to make a more informed decision around the company. You can see the 2 risks we have identified for SDI by visiting our risks dashboard for free on our platform here.

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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. Thank you for reading.