Smiths Group plc's (LON:SMIN) Stock Is Going Strong: Is the Market Following Fundamentals?

Smiths Group's (LON:SMIN) stock is up by a considerable 10.0% over the past month. Given that the market rewards strong financials in the long-term, we wonder if that is the case in this instance. Specifically, we decided to study Smiths Group's ROE in this article.

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 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?

The formula for return on equity is:

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

So, based on the above formula, the ROE for Smiths Group is:

11% = UK£234m ÷ UK£2.1b (Based on the trailing twelve months to January 2024).

The 'return' is the profit over the last twelve months. So, this means that for every £1 of its shareholder's investments, the company generates a profit of £0.11.

What Is The Relationship Between ROE And Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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. 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.

A Side By Side comparison of Smiths Group's Earnings Growth And 11% ROE

At first glance, Smiths Group seems to have a decent ROE. On comparing with the average industry ROE of 7.7% the company's ROE looks pretty remarkable. This certainly adds some context to Smiths Group's decent 14% net income growth seen over the past five years.

We then performed a comparison between Smiths Group's net income growth with the industry, which revealed that the company's growth is similar to the average industry growth of 15% in the same 5-year period.

Earnings growth is an important metric to consider when valuing a stock. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Has the market priced in the future outlook for SMIN? You can find out in our latest intrinsic value infographic research report.

Is Smiths Group Using Its Retained Earnings Effectively?

The high three-year median payout ratio of 85% (or a retention ratio of 15%) for Smiths Group suggests that the company's growth wasn't really hampered despite it returning most of its income to its shareholders.

Additionally, Smiths Group has paid dividends over a period of at least ten years which means that the company is pretty serious about sharing its profits with shareholders. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 39% over the next three years. The fact that the company's ROE is expected to rise to 16% over the same period is explained by the drop in the payout ratio.

Conclusion

On the whole, we feel that Smiths Group's performance has been quite good. In particular, its high ROE is quite noteworthy and also the probable explanation behind its considerable earnings growth. Yet, the company is retaining a small portion of its profits. Which means that the company has been able to grow its earnings in spite of it, so that's not too bad. With that said, the latest industry analyst forecasts reveal that the company's earnings are expected to accelerate. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.