Scales' (NZSE:SCL) stock up by 4.8% over the past week. However, in this article, we decided to focus on its weak financials, as long-term fundamentals ultimately dictate market outcomes. Specifically, we decided to study Scales' ROE in this article.
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
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 Scales is:
7.0% = NZ$27m ÷ NZ$378m (Based on the trailing twelve months to December 2020).
The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each NZ$1 of shareholders' capital it has, the company made NZ$0.07 in profit.
What Has ROE Got To Do With Earnings Growth?
So far, we've learned that ROE is a measure of a company's profitability. 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. 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.
A Side By Side comparison of Scales' Earnings Growth And 7.0% ROE
When you first look at it, Scales' ROE doesn't look that attractive. However, given that the company's ROE is similar to the average industry ROE of 6.8%, we may spare it some thought. But then again, Scales' five year net income shrunk at a rate of 4.1%. Remember, the company's ROE is a bit low to begin with. Therefore, the decline in earnings could also be the result of this.
That being said, we compared Scales' 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 3.6% in the same period.
Earnings growth is an important metric to consider when valuing a stock. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. Doing so will help them establish if the stock's future looks promising or ominous. What is SCL worth today? The intrinsic value infographic in our free research report helps visualize whether SCL is currently mispriced by the market.
Is Scales Efficiently Re-investing Its Profits?
Scales' declining earnings is not surprising given how the company is spending most of its profits in paying dividends, judging by its three-year median payout ratio of 93% (or a retention ratio of 7.1%). With only very little left to reinvest into the business, growth in earnings is far from likely. You can see the 2 risks we have identified for Scales by visiting our risks dashboard for free on our platform here.
Additionally, Scales has paid dividends over a period of six years, which means that the company's management is rather focused on keeping up its dividend payments, regardless of the shrinking earnings. Based on the latest analysts' estimates, we found that the company's future payout ratio over the next three years is expected to hold steady at 82%. However, Scales' ROE is predicted to rise to 9.5% despite there being no anticipated change in its payout ratio.
On the whole, Scales' performance is quite a big let-down. 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 industry analyst forecasts show that the analysts are expecting to see a huge improvement in the company's earnings growth rate. 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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