Softcat plc's (LON:SCT) Stock Is Going Strong: Is the Market Following Fundamentals?

Softcat (LON:SCT) has had a great run on the share market with its stock up by a significant 34% over the last three months. Given the company's impressive performance, we decided to study its financial indicators more closely as a company's financial health over the long-term usually dictates market outcomes. Particularly, we will be paying attention to Softcat's ROE today.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

See our latest analysis for Softcat

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 Softcat is:

54% = UK£76m ÷ UK£141m (Based on the trailing twelve months to July 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 £0.54 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. 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.

Softcat's Earnings Growth And 54% ROE

Firstly, we acknowledge that Softcat has a significantly high ROE. Second, a comparison with the average ROE reported by the industry of 10% also doesn't go unnoticed by us. So, the substantial 21% net income growth seen by Softcat over the past five years isn't overly surprising.

We then performed a comparison between Softcat's net income growth with the industry, which revealed that the company's growth is similar to the average industry growth of 18% 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. This then helps them determine if the stock is placed for a bright or bleak future. 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 Softcat is trading on a high P/E or a low P/E, relative to its industry.

Is Softcat Using Its Retained Earnings Effectively?

Softcat's three-year median payout ratio is a pretty moderate 43%, meaning the company retains 57% of its income. By the looks of it, the dividend is well covered and Softcat is reinvesting its profits efficiently as evidenced by its exceptional growth which we discussed above.

Besides, Softcat has been paying dividends over a period of five years. This shows that the company is committed to sharing profits with its shareholders. Our latest analyst data shows that the future payout ratio of the company is expected to rise to 78% over the next three years. Despite the higher expected payout ratio, the company's ROE is not expected to change by much.

Conclusion

On the whole, we feel that Softcat's performance has been quite good. Particularly, we like that the company is reinvesting heavily into its business, and at a high rate of return. Unsurprisingly, this has led to an impressive earnings growth. That being so, a study of the latest analyst forecasts show that the company is expected to see a slowdown in its future earnings growth. 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. 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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