Does Sanlam Limited's (JSE:SLM) Weak Fundamentals Mean That The Market Could Correct Its Share Price?

Sanlam (JSE:SLM) has had a great run on the share market with its stock up by a significant 13% over the last three months. However, in this article, we decided to focus on its weak fundamentals, as long-term financial performance of a business is what ultimatley dictates market outcomes. In this article, we decided to focus on Sanlam's ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Put another way, it reveals the company's success at turning shareholder investments into profits.

See our latest analysis for Sanlam

How To Calculate Return On Equity?

The formula for ROE is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Sanlam is:

1.7% = R1.3b ÷ R77b (Based on the trailing twelve months to June 2020).

The 'return' refers to a company's earnings over the last year. That means that for every ZAR1 worth of shareholders' equity, the company generated ZAR0.02 in profit.

What Is The Relationship Between ROE And Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. Assuming all else is equal, companies that have both a higher return on equity and higher profit retention are usually the ones that have a higher growth rate when compared to companies that don't have the same features.

Sanlam's Earnings Growth And 1.7% ROE

It is quite clear that Sanlam's ROE is rather low. Even when compared to the industry average of 6.6%, the ROE figure is pretty disappointing. For this reason, Sanlam's five year net income decline of 8.0% is not surprising given its lower ROE. We reckon that there could also be other factors at play here. For instance, the company has a very high payout ratio, or is faced with competitive pressures.

So, as a next step, we compared Sanlam's performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 0.9% in the same period.

Earnings growth is a huge factor in stock valuation. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. Doing so will help them establish if the stock's future looks promising or ominous. If you're wondering about Sanlam's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Sanlam Using Its Retained Earnings Effectively?

Sanlam has a high three-year median payout ratio of 59% (that is, it is retaining 41% of its profits). This suggests that the company is paying most of its profits as dividends to its shareholders. This goes some way in explaining why its earnings have been shrinking. The business is only left with a small pool of capital to reinvest - A vicious cycle that doesn't benefit the company in the long-run. To know the 3 risks we have identified for Sanlam visit our risks dashboard for free.

Moreover, Sanlam has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over 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 66%. Still, forecasts suggest that Sanlam's future ROE will rise to 16% even though the the company's payout ratio is not expected to change by much.

Conclusion

Overall, we would be extremely cautious before making any decision on Sanlam. Because the company is not reinvesting much into the business, and given the low ROE, it's not surprising to see the lack or absence of growth in its earnings. 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 latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.

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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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