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Sims Limited's (ASX:SGM) Has Had A Decent Run On The Stock market: Are Fundamentals In The Driver's Seat?

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Most readers would already know that Sims' (ASX:SGM) stock increased by 3.6% over the past week. Given that stock prices are usually aligned with a company's financial performance in the long-term, we decided to investigate if the company's decent financials had a hand to play in the recent price move. In this article, we decided to focus on Sims' 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. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

Check out our latest analysis for Sims

How Do You Calculate Return On Equity?

Return on equity can be calculated by using the formula:

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

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

11% = AU$229m ÷ AU$2.1b (Based on the trailing twelve months to June 2021).

The 'return' is the income the business earned over the last year. So, this means that for every A$1 of its shareholder's investments, the company generates a profit of A$0.11.

What Is The Relationship Between ROE And 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. 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 Sims' Earnings Growth And 11% ROE

To begin with, Sims seems to have a respectable ROE. And on comparing with the industry, we found that the the average industry ROE is similar at 13%. However, while Sims has a pretty respectable ROE, its five year net income decline rate was 16% . So, there might be some other aspects that could explain this. 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 24% 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. Doing so will help them establish if the stock's future looks promising or ominous. Has the market priced in the future outlook for SGM? You can find out in our latest intrinsic value infographic research report.

Is Sims Efficiently Re-investing Its Profits?

Sims' 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 52% (or a retention ratio of 48%). 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. You can see the 2 risks we have identified for Sims by visiting our risks dashboard for free on our platform here.

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. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 40% over the next three years. However, Sims' future ROE is expected to decline to 8.6% despite the expected decline in its payout ratio. We infer that there could be other factors that could be steering the foreseen decline in the company's ROE.

Conclusion

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. Bear in mind, the company reinvests a small portion of its profits, which means that investors aren't reaping the benefits of the high rate of return. That being so, the latest industry analyst forecasts show that analysts are forecasting a slight improvement in the company's future earnings growth. The company's existing shareholders might have some respite after all. 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.

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.