Should Weakness in SCGM Bhd's (KLSE:SCGM) Stock Be Seen As A Sign That Market Will Correct The Share Price Given Decent Financials?

With its stock down 16% over the past three months, it is easy to disregard SCGM Bhd (KLSE:SCGM). 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 SCGM Bhd's ROE today.

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. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

View our latest analysis for SCGM Bhd

How To Calculate Return On Equity?

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 SCGM Bhd is:

13% = RM23m ÷ RM176m (Based on the trailing twelve months to July 2020).

The 'return' is the amount earned after tax over the last twelve months. That means that for every MYR1 worth of shareholders' equity, the company generated MYR0.13 in profit.

Why Is ROE Important For 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.

SCGM Bhd's Earnings Growth And 13% ROE

At first glance, SCGM Bhd seems to have a decent ROE. On comparing with the average industry ROE of 8.3% the company's ROE looks pretty remarkable. Needless to say, we are quite surprised to see that SCGM Bhd's net income shrunk at a rate of 23% over the past five years. We reckon that there could be some other factors at play here that are preventing the company's growth. Such as, the company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.

That being said, we compared SCGM Bhd's performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 4.3% in the same period.

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

Is SCGM Bhd Using Its Retained Earnings Effectively?

Looking at its three-year median payout ratio of 49% (or a retention ratio of 51%) which is pretty normal, SCGM Bhd's declining earnings is rather baffling as one would expect to see a fair bit of growth when a company is retaining a good portion of its profits. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.

Additionally, SCGM Bhd 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. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 40%. Still, forecasts suggest that SCGM Bhd's future ROE will rise to 16% even though the the company's payout ratio is not expected to change by much.

Conclusion

In total, it does look like SCGM Bhd has some positive aspects to its business. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE and and a high reinvestment rate. We believe that there might be some outside factors that could be having a negative impact on the business. 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. 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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