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SThree (LON:STEM) has had a great run on the share market with its stock up by a significant 16% over the last three months. As most would know, fundamentals are what usually guide market price movements over the long-term, so we decided to look at the company's key financial indicators today to determine if they have any role to play in the recent price movement. Particularly, we will be paying attention to SThree'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 other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
How To 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 SThree is:
26% = UK£33m ÷ UK£124m (Based on the trailing twelve months to May 2020).
The 'return' is the profit over the last twelve months. Another way to think of that is that for every £1 worth of equity, the company was able to earn £0.26 in profit.
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. Assuming everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.
A Side By Side comparison of SThree's Earnings Growth And 26% ROE
First thing first, we like that SThree has an impressive ROE. Second, a comparison with the average ROE reported by the industry of 16% also doesn't go unnoticed by us. This probably laid the groundwork for SThree's moderate 10% net income growth seen over the past five years.
As a next step, we compared SThree's net income growth with the industry and were disappointed to see that the company's growth is lower than the industry average growth of 14% in the same period.
Earnings growth is a huge factor in stock valuation. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. If you're wondering about SThree's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.
Is SThree Efficiently Re-investing Its Profits?
While SThree has a three-year median payout ratio of 54% (which means it retains 46% of profits), the company has still seen a fair bit of earnings growth in the past, meaning that its high payout ratio hasn't hampered its ability to grow.
Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 50% of its profits over the next three years. However, SThree's future ROE is expected to decline to 20% despite there being not much change anticipated in the company's payout ratio.
Overall, we feel that SThree certainly does have some positive factors to consider. Its earnings have grown respectably as we saw earlier, which was likely due to the company reinvesting its earnings at a pretty high rate of return. However, given the high ROE, we do think that the company is reinvesting a small portion of its profits. This could likely be preventing the company from growing to its full extent. With that said, the latest industry analyst forecasts reveal that the company's earnings are expected to accelerate. 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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