Should Weakness in Step One Clothing Limited's (ASX:STP) Stock Be Seen As A Sign That Market Will Correct The Share Price Given Decent Financials?

It is hard to get excited after looking at Step One Clothing's (ASX:STP) recent performance, when its stock has declined 33% over the past three months. 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 Step One Clothing's ROE today.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

Check out our latest analysis for Step One Clothing

How Do You Calculate Return On Equity?

Return on equity 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 Step One Clothing is:

24% = AU$12m ÷ AU$52m (Based on the trailing twelve months to June 2024).

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$0.24 in profit.

What Is The Relationship Between ROE And Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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 everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.

A Side By Side comparison of Step One Clothing's Earnings Growth And 24% ROE

First thing first, we like that Step One Clothing has an impressive ROE. Additionally, the company's ROE is higher compared to the industry average of 17% which is quite remarkable. Under the circumstances, Step One Clothing's considerable five year net income growth of 47% was to be expected.

Next, on comparing with the industry net income growth, we found that Step One Clothing's growth is quite high when compared to the industry average growth of 15% in the same period, which is great to see.

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 Step One Clothing is trading on a high P/E or a low P/E, relative to its industry.

Is Step One Clothing Using Its Retained Earnings Effectively?

Step One Clothing's very high three-year median payout ratio of 136% suggests that the company is paying more to its shareholders than what it is earning. Despite this, the company's earnings grew significantly as we saw above. With that said, it could be worth keeping an eye on the high payout ratio as that's a huge risk. You can see the 2 risks we have identified for Step One Clothing by visiting our risks dashboard for free on our platform here.

Along with seeing a growth in earnings, Step One Clothing only recently started paying dividends. Its quite possible that the company was looking to impress its shareholders. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 98% over the next three years. The fact that the company's ROE is expected to rise to 32% over the same period is explained by the drop in the payout ratio.

Conclusion

Overall, we feel that Step One Clothing certainly does have some positive factors to consider. Namely, its high earnings growth, which was likely due to its high ROE. However, investors could have benefitted even more from the high ROE, had the company been reinvesting more of its earnings. As discussed earlier, the company is retaining hardly any of its profits. Having said that, the company's earnings growth is expected to slow down, as forecasted in the current analyst estimates. 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. 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.