SThree plc's (LON:STEM) Stock Has Seen Strong Momentum: Does That Call For Deeper Study Of Its Financial Prospects?

SThree (LON:STEM) has had a great run on the share market with its stock up by a significant 32% over the last three months. We wonder if and what role the company's financials play in that price change as a company's long-term fundamentals usually dictate market outcomes. In this article, we decided to focus on SThree's ROE.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

View our latest analysis for SThree

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 SThree is:

26% = UK£33m ÷ UK£124m (Based on the trailing twelve months to May 2020).

The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each £1 of shareholders' capital it has, the company made £0.26 in profit.

What Has ROE Got To Do With Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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 all else is equal, companies that have both a higher return on equity and higher profit retention are usually the ones that have a higher growth rate when compared to companies that don't have the same features.

A Side By Side comparison of SThree's Earnings Growth And 26% ROE

Firstly, we acknowledge that SThree has a significantly high ROE. Secondly, even when compared to the industry average of 13% the company's ROE is quite impressive. This likely paved the way for the modest 10% net income growth seen by SThree over the past five years. growth

Next, on comparing with the industry net income growth, we found that SThree's reported growth was lower than the industry growth of 14% in the same period, which is not something we like to see.

Earnings growth is a huge factor in stock valuation. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. This then helps them determine if the stock is placed for a bright or bleak future. If you're wondering about SThree's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is SThree Efficiently Re-investing Its Profits?

While the company did pay out a portion of its dividend in the past, it currently doesn't pay a dividend. We infer that the company has been reinvesting all of its profits to grow its business.

Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 57%. Regardless, SThree's ROE is speculated to decline to 20% despite there being no anticipated change in its payout ratio.

Conclusion

In total, it does look like SThree has some positive aspects to its business. Its earnings have grown respectably as we saw earlier, which was likely due to the company reinvesting its earnings at a pretty high rate of return. However, given the high ROE, we do think that the company is reinvesting a small portion of its profits. This could likely be preventing the company from growing to its full extent. The latest industry analyst forecasts show that the company is expected to maintain its current 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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