Sonata Software Limited's (NSE:SONATSOFTW) Stock Has Shown Weakness Lately But Financial Prospects Look Decent: Is The Market Wrong?

Sonata Software (NSE:SONATSOFTW) has had a rough three months with its share price down 37%. However, stock prices are usually driven by a company’s financials over the long term, which in this case look pretty respectable. Particularly, we will be paying attention to Sonata Software's ROE today.

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

We've found 21 US stocks that are forecast to pay a dividend yield of over 6% next year. See the full list for free.

How Is ROE Calculated?

Return on equity 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 Sonata Software is:

28% = ₹4.3b ÷ ₹15b (Based on the trailing twelve months to December 2024).

The 'return' is the amount earned after tax over the last twelve months. One way to conceptualize this is that for each ₹1 of shareholders' capital it has, the company made ₹0.28 in profit.

View our latest analysis for Sonata Software

Why Is ROE Important For Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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. 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.

Sonata Software's Earnings Growth And 28% ROE

First thing first, we like that Sonata Software has an impressive ROE. Secondly, even when compared to the industry average of 15% the company's ROE is quite impressive. This probably laid the groundwork for Sonata Software's moderate 8.0% net income growth seen over the past five years.

As a next step, we compared Sonata Software'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 26% in the same period.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). Doing so will help them establish if the stock's future looks promising or ominous. 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 Sonata Software is trading on a high P/E or a low P/E, relative to its industry.

Is Sonata Software Using Its Retained Earnings Effectively?

The high three-year median payout ratio of 53% (or a retention ratio of 47%) for Sonata Software suggests that the company's growth wasn't really hampered despite it returning most of its income to its shareholders.

Additionally, Sonata Software 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. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 30% over the next three years. However, the company's ROE is not expected to change by much despite the lower expected payout ratio.

Summary

On the whole, we do feel that Sonata Software has some positive attributes. Its earnings growth is decent, and the high ROE does contribute to that growth. However, investors could have benefitted even more from the high ROE, had the company been reinvesting more of its earnings. That being so, the latest analyst forecasts show that the company will continue to see an expansion in its earnings. 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.

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.