Servcorp Limited's (ASX:SRV) Financial Prospects Don't Look Very Positive: Could It Mean A Stock Price Drop In The Future?
Servcorp's (ASX:SRV) stock is up by 3.0% over the past month. However, in this article, we decided to focus on its weak financials, as long-term fundamentals ultimately dictate market outcomes. In this article, we decided to focus on Servcorp's ROE.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
Check out our latest analysis for Servcorp
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 Servcorp is:
3.7% = AU$7.5m ÷ AU$206m (Based on the trailing twelve months to December 2020).
The 'return' refers to a company's earnings over the last year. That means that for every A$1 worth of shareholders' equity, the company generated A$0.04 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. 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.
Servcorp's Earnings Growth And 3.7% ROE
It is hard to argue that Servcorp's ROE is much good in and of itself. Even compared to the average industry ROE of 5.1%, the company's ROE is quite dismal. For this reason, Servcorp's five year net income decline of 33% is not surprising given its lower ROE. However, there could also be other factors causing the earnings to decline. For example, the business has allocated capital poorly, or that the company has a very high payout ratio.
As a next step, we compared Servcorp's performance with the industry and found thatServcorp's performance is depressing even when compared with the industry, which has shrunk its earnings at a rate of 9.2% in the same period, which is a slower than the company.
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 Servcorp is trading on a high P/E or a low P/E, relative to its industry.
Is Servcorp Using Its Retained Earnings Effectively?
Servcorp's high three-year median payout ratio of 231% suggests that the company is depleting its resources to keep up its dividend payments, and this shows in its shrinking earnings. Its usually very hard to sustain dividend payments that are higher than reported profits. Our risks dashboard should have the 3 risks we have identified for Servcorp.
In addition, Servcorp has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 63% over the next three years. As a result, the expected drop in Servcorp's payout ratio explains the anticipated rise in the company's future ROE to 14%, over the same period.
Summary
On the whole, Servcorp's performance is quite a big let-down. The low ROE, combined with the fact that the company is paying out almost if not all, of its profits as dividends, has resulted in 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.
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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