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Serica Energy's (LON:SQZ) stock is up by 2.6% over the past week. Given that the market rewards strong financials in the long-term, we wonder if that is the case in this instance. In this article, we decided to focus on Serica Energy's ROE.
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. Put another way, it reveals the company's success at turning shareholder investments into profits.
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 Serica Energy is:
32% = UK£64m ÷ UK£198m (Based on the trailing twelve months to December 2019).
The 'return' is the income the business earned over the last year. So, this means that for every £1 of its shareholder's investments, the company generates a profit of £0.32.
What Has ROE Got To Do With 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.
Serica Energy's Earnings Growth And 32% ROE
Firstly, we acknowledge that Serica Energy has a significantly high ROE. Second, a comparison with the average ROE reported by the industry of 9.6% also doesn't go unnoticed by us. So, the substantial 72% net income growth seen by Serica Energy over the past five years isn't overly surprising.
Next, on comparing with the industry net income growth, we found that Serica Energy's growth is quite high when compared to the industry average growth of 35% in the same period, which is great to see.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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. What is SQZ worth today? The intrinsic value infographic in our free research report helps visualize whether SQZ is currently mispriced by the market.
Is Serica Energy Using Its Retained Earnings Effectively?
Serica Energy has a really low three-year median payout ratio of 12%, meaning that it has the remaining 88% left over to reinvest into its business. This suggests that the management is reinvesting most of the profits to grow the business as evidenced by the growth seen by the company.
Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 11%. Still, forecasts suggest that Serica Energy's future ROE will drop to 22% even though the the company's payout ratio is not expected to change by much.
In total, we are pretty happy with Serica Energy's performance. In particular, it's great to see that the company is investing heavily into its business and along with a high rate of return, that has resulted in a sizeable growth in its earnings. With that said, on studying the latest analyst forecasts, we found that while the company has seen growth in its past earnings, analysts expect its future earnings to shrink. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page for the company.
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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