South32 Limited's (ASX:S32) Stock Going Strong But Fundamentals Look Weak: What Implications Could This Have On The Stock?

South32's (ASX:S32) stock is up by a considerable 27% over the past three months. However, we decided to pay close attention to its weak financials as we are doubtful that the current momentum will keep up, given the scenario. Specifically, we decided to study South32's 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. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

See our latest analysis for South32

How To Calculate Return On Equity?

The formula for ROE is:

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

So, based on the above formula, the ROE for South32 is:

1.6% = US$142m ÷ US$9.0b (Based on the trailing twelve months to June 2021).

The 'return' is the profit over the last twelve months. Another way to think of that is that for every A$1 worth of equity, the company was able to earn A$0.02 in profit.

What Is The Relationship Between ROE And Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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 South32's Earnings Growth And 1.6% ROE

It is hard to argue that South32's ROE is much good in and of itself. Even when compared to the industry average of 13%, the ROE figure is pretty disappointing. For this reason, South32's five year net income decline of 11% is not surprising given its lower ROE. We reckon that there could also be other factors at play here. Such as - low earnings retention or poor allocation of capital.

That being said, we compared South32's performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 24% 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. Has the market priced in the future outlook for S32? You can find out in our latest intrinsic value infographic research report.

Is South32 Using Its Retained Earnings Effectively?

With a high three-year median payout ratio of 54% (implying that 46% of the profits are retained), most of South32's profits are being paid to shareholders, which explains the company's shrinking earnings. With only a little being reinvested into the business, earnings growth would obviously be low or non-existent.

In addition, South32 has been paying dividends over a period of five years suggesting that keeping up dividend payments is preferred by the management even though earnings have been in decline. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 55%. Regardless, the future ROE for South32 is predicted to rise to 13% despite there being not much change expected in its payout ratio.

Summary

Overall, we would be extremely cautious before making any decision on South32. Because the company is not reinvesting much into the business, and given the low ROE, it's not surprising to see the lack or absence of growth in its earnings. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. 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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.