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

Servcorp (ASX:SRV) has had a great run on the share market with its stock up by a significant 31% over the last 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 Servcorp'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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

View our latest analysis for Servcorp

How Is ROE Calculated?

The formula for ROE is:

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

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

3.1% = AU$6.9m ÷ AU$221m (Based on the trailing twelve months to June 2020).

The 'return' is the income the business earned over the last year. That means that for every A$1 worth of shareholders' equity, the company generated A$0.03 in profit.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. 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.

Servcorp's Earnings Growth And 3.1% ROE

It is quite clear that Servcorp's ROE is rather low. A comparison with the industry shows that the company's ROE is pretty similar to the average industry ROE of 3.5%. Therefore, it might not be wrong to say that the five year net income decline of 28% seen by Servcorp was possibly a result of the disappointing ROE.

Next, when we compared with the industry, which has shrunk its earnings at a rate of 5.9% in the same period, we still found Servcorp's performance to be quite bleak, because the company has been shrinking its earnings faster than the industry.

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. One good indicator of expected earnings growth is the P/E ratio which determines the price the market is willing to pay for a stock based on its earnings prospects. So, you may want to check if Servcorp is trading on a high P/E or a low P/E, relative to its industry.

Is Servcorp Making Efficient Use Of Its Profits?

Servcorp's high three-year median payout ratio of 111% suggests that the company is depleting its resources to keep up its dividend payments, and this shows in its shrinking earnings. Paying a dividend beyond their means is usually not viable over the long term. You can see the 3 risks we have identified for Servcorp by visiting our risks dashboard for free on our platform here.

Moreover, Servcorp has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over earnings growth. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 63% over the next three years. The fact that the company's ROE is expected to rise to 13% over the same period is explained by the drop in the payout ratio.

Conclusion

Overall, we would be extremely cautious before making any decision on Servcorp. The low ROE, combined with the fact that the company is paying out almost if not all, of its profits as dividends, has resulted in the lack or absence of growth in its earnings. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page 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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