Smith & Nephew plc's (LON:SN.) Has Been On A Rise But Financial Prospects Look Weak: Is The Stock Overpriced?

Smith & Nephew (LON:SN.) has had a great run on the share market with its stock up by a significant 30% over the last three months. However, in this article, we decided to focus on its weak fundamentals, as long-term financial performance of a business is what ultimately dictates market outcomes. In this article, we decided to focus on Smith & Nephew's ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

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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 Smith & Nephew is:

8.9% = US$491m ÷ US$5.5b (Based on the trailing twelve months to June 2025).

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 £0.09 in profit.

Check out our latest analysis for Smith & Nephew

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. 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.

Smith & Nephew's Earnings Growth And 8.9% ROE

At first glance, Smith & Nephew's ROE doesn't look very promising. However, given that the company's ROE is similar to the average industry ROE of 8.9%, we may spare it some thought. But then again, Smith & Nephew's five year net income shrunk at a rate of 7.1%. Remember, the company's ROE is a bit low to begin with. Therefore, the decline in earnings could also be the result of this.

However, when we compared Smith & Nephew's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 12% in the same period. This is quite worrisome.

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. This then helps them determine if the stock is placed for a bright or bleak future. What is SN. worth today? The intrinsic value infographic in our free research report helps visualize whether SN. is currently mispriced by the market.

Is Smith & Nephew Efficiently Re-investing Its Profits?

Smith & Nephew's very high three-year median payout ratio of 107% 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 higher than reported profits is not a sustainable move. You can see the 2 risks we have identified for Smith & Nephew by visiting our risks dashboard for free on our platform here.

Additionally, Smith & Nephew has paid dividends over a period of at least ten years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 40% over the next three years. As a result, the expected drop in Smith & Nephew's payout ratio explains the anticipated rise in the company's future ROE to 15%, over the same period.

Conclusion

In total, we would have a hard think before deciding on any investment action concerning Smith & Nephew. Particularly, its ROE is a huge disappointment, not to mention its lack of proper reinvestment into the business. As a result its earnings growth has also been quite disappointing. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. 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.

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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.