Smiths Group plc's (LON:SMIN) Dismal Stock Performance Reflects Weak Fundamentals

Smiths Group (LON:SMIN) has had a rough three months with its share price down 4.4%. To decide if this trend could continue, we decided to look at its weak fundamentals as they shape the long-term market trends. In this article, we decided to focus on Smiths Group's ROE.

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.

View our latest analysis for Smiths Group

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 Smiths Group is:

2.8% = UK£67m ÷ UK£2.4b (Based on the trailing twelve months to July 2020).

The 'return' is the yearly profit. One way to conceptualize this is that for each £1 of shareholders' capital it has, the company made £0.03 in profit.

What Has ROE Got To Do With 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 Smiths Group's Earnings Growth And 2.8% ROE

It is hard to argue that Smiths Group's ROE is much good in and of itself. Even when compared to the industry average of 8.2%, the ROE figure is pretty disappointing. For this reason, Smiths Group's five year net income decline of 24% 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.

However, when we compared Smiths Group's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 3.0% in the same period. This is quite worrisome.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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. 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 Smiths Group is trading on a high P/E or a low P/E, relative to its industry.

Is Smiths Group Efficiently Re-investing Its Profits?

Smiths Group's very high three-year median payout ratio of 129% over the last three years suggests that the company is paying its shareholders more than what it is earning and this explains the company's shrinking earnings. Paying a dividend beyond their means is usually not viable over the long term. To know the 4 risks we have identified for Smiths Group visit our risks dashboard for free.

Moreover, Smiths Group 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. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 50% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 12%, over the same period.

Summary

Overall, we would be extremely cautious before making any decision on Smiths Group. Specifically, it has shown quite an unsatisfactory performance as far as earnings growth is concerned, and a poor ROE and an equally poor rate of reinvestment seem to be the reason behind this inadequate performance. That being so, the latest industry analyst forecasts show that the analysts are expecting to see a huge improvement in the company's earnings growth rate. 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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