Spirax-Sarco Engineering plc's (LON:SPX) Stock Has Shown Weakness Lately But Financial Prospects Look Decent: Is The Market Wrong?

It is hard to get excited after looking at Spirax-Sarco Engineering's (LON:SPX) recent performance, when its stock has declined 11% over the past three months. However, the company's fundamentals look pretty decent, and long-term financials are usually aligned with future market price movements. Specifically, we decided to study Spirax-Sarco Engineering's ROE in this article.

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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

View our latest analysis for Spirax-Sarco Engineering

How Is ROE Calculated?

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 Spirax-Sarco Engineering is:

16% = UK£184m ÷ UK£1.2b (Based on the trailing twelve months to December 2023).

The 'return' is the profit over the last twelve months. Another way to think of that is that for every £1 worth of equity, the company was able to earn £0.16 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. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. 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.

Spirax-Sarco Engineering's Earnings Growth And 16% ROE

At first glance, Spirax-Sarco Engineering seems to have a decent ROE. And on comparing with the industry, we found that the the average industry ROE is similar at 14%. However, we are curious as to how Spirax-Sarco Engineering's decent returns still resulted in flat growth for Spirax-Sarco Engineering in the past five years. Based on this, we feel that there might be other reasons which haven't been discussed so far in this article that could be hampering the company's growth. Such as, the company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.

As a next step, we compared Spirax-Sarco Engineering's net income growth with the industry and were disappointed to see that the company's growth is lower than the industry average growth of 9.8% in the same period.

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. If you're wondering about Spirax-Sarco Engineering's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Spirax-Sarco Engineering Using Its Retained Earnings Effectively?

Despite having a normal three-year median payout ratio of 48% (implying that the company keeps 52% of its income) over the last three years, Spirax-Sarco Engineering has seen a negligible amount of growth in earnings as we saw above. So there could be some other explanation in that regard. For instance, the company's business may be deteriorating.

In addition, Spirax-Sarco Engineering has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 47%. Still, forecasts suggest that Spirax-Sarco Engineering's future ROE will rise to 21% even though the the company's payout ratio is not expected to change by much.

Conclusion

On the whole, we do feel that Spirax-Sarco Engineering has some positive attributes. However, given the high ROE and high profit retention, we would expect the company to be delivering strong earnings growth, but that isn't the case here. This suggests that there might be some external threat to the business, that's hampering its growth. With that said, the latest industry analyst forecasts reveal that the company's earnings are expected to accelerate. 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.