It is hard to get excited after looking at Scales' (NZSE:SCL) recent performance, when its stock has declined 4.3% over the past three months. Given that stock prices are usually driven by a company’s fundamentals over the long term, which in this case look pretty weak, we decided to study the company's key financial indicators. Specifically, we decided to study Scales' ROE in this article.
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.
How Do You Calculate Return On Equity?
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 Scales is:
7.3% = NZ$28m ÷ NZ$376m (Based on the trailing twelve months to June 2020).
The 'return' is the yearly profit. That means that for every NZ$1 worth of shareholders' equity, the company generated NZ$0.07 in profit.
What Is The Relationship Between ROE And 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. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don’t share these attributes.
Scales' Earnings Growth And 7.3% ROE
At first glance, Scales' ROE doesn't look very promising. However, given that the company's ROE is similar to the average industry ROE of 7.7%, we may spare it some thought. Still, Scales has seen a flat net income growth over the past five years. Bear in mind, the company's ROE is not very high. Hence, this provides some context to the flat earnings growth seen by the company.
We then compared Scales' net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 6.9% in the same period, which is a bit concerning.
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 Scales''s valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.
Is Scales Using Its Retained Earnings Effectively?
Scales has a high three-year median payout ratio of 92% (or a retention ratio of 8.5%), meaning that the company is paying most of its profits as dividends to its shareholders. This does go some way in explaining why there's been no growth in its earnings.
In addition, Scales has been paying dividends over a period of six years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 87%. Still, forecasts suggest that Scales' future ROE will rise to 8.9% even though the the company's payout ratio is not expected to change by much.
In total, we would have a hard think before deciding on any investment action concerning Scales. 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. That being so, the latest analyst forecasts show that the company will continue to see an expansion in its earnings. 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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