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Declining Stock and Decent Financials: Is The Market Wrong About Sims Limited (ASX:SGM)?

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·4 min read
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With its stock down 15% over the past three months, it is easy to disregard Sims (ASX:SGM). However, stock prices are usually driven by a company’s financials over the long term, which in this case look pretty respectable. In this article, we decided to focus on Sims' ROE.

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.

Check out our latest analysis for Sims

How Is ROE Calculated?

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 Sims is:

19% = AU$430m ÷ AU$2.3b (Based on the trailing twelve months to December 2021).

The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each A$1 of shareholders' capital it has, the company made A$0.19 in profit.

Why Is ROE Important For 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. 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.

Sims' Earnings Growth And 19% ROE

To begin with, Sims seems to have a respectable ROE. Even when compared to the industry average of 16% the company's ROE looks quite decent. For this reason, Sims' five year net income decline of 10% raises the question as to why the decent ROE didn't translate into growth. Based on this, we feel that there might be other reasons which haven't been discussed so far in this article that could be hampering the company's growth. These include low earnings retention or poor allocation of capital.

That being said, we compared Sims' 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 26% in the same period.

past-earnings-growth
past-earnings-growth

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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. 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 Sims is trading on a high P/E or a low P/E, relative to its industry.

Is Sims Using Its Retained Earnings Effectively?

Looking at its three-year median payout ratio of 34% (or a retention ratio of 66%) which is pretty normal, Sims' 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. It looks like there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.

Additionally, Sims 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 33%. Regardless, Sims' ROE is speculated to decline to 14% despite there being no anticipated change in its payout ratio.

Summary

Overall, we feel that Sims certainly does have some positive factors to consider. 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. Additionally, the latest industry analyst forecasts show that analysts expect the company's earnings to continue to shrink in the future. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts 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.