Smith & Nephew plc's (LON:SN.) Has Been On A Rise But Financial Prospects Look Weak: Is The Stock Overpriced?
Most readers would already be aware that Smith & Nephew's (LON:SN.) stock increased significantly by 22% over the past three months. However, in this article, we decided to focus on its weak fundamentals, as long-term financial performance of a business is what ultimately dictates market outcomes. Particularly, we will be paying attention to Smith & Nephew's ROE today.
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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.
Check out our latest analysis for Smith & Nephew
How Is ROE Calculated?
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 Smith & Nephew is:
4.2% = US$218m ÷ US$5.2b (Based on the trailing twelve months to July 2023).
The 'return' is the income the business earned over the last year. That means that for every £1 worth of shareholders' equity, the company generated £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. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. 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 Smith & Nephew's Earnings Growth And 4.2% ROE
When you first look at it, Smith & Nephew's ROE doesn't look that attractive. However, its ROE is similar to the industry average of 4.3%, so we won't completely dismiss the company. But Smith & Nephew saw a five year net income decline of 17% over the past five years. Bear in mind, the company does have a slightly low ROE. Hence, this goes some way in explaining the shrinking earnings.
Next, when we compared with the industry, which has shrunk its earnings at a rate of 9.5% in the same 5-year period, we still found Smith & Nephew's performance to be quite bleak, because the company has been shrinking its earnings faster than the industry.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). This then helps them determine if the stock is placed for a bright or bleak future. What is SN. worth today? The intrinsic value infographic in our free research report helps visualize whether SN. is currently mispriced by the market.
Is Smith & Nephew Using Its Retained Earnings Effectively?
Smith & Nephew's 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 70% (or a retention ratio of 30%). 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. Our risks dashboard should have the 4 risks we have identified for Smith & Nephew.
Moreover, Smith & Nephew 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. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 42% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 16%, over the same period.
Summary
In total, we would have a hard think before deciding on any investment action concerning Smith & Nephew. 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. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.
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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.
