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Declining Stock and Solid Fundamentals: Is The Market Wrong About Smith & Nephew plc (LON:SN.)?

Simply Wall St

It is hard to get excited after looking at Smith & Nephew's (LON:SN.) recent performance, when its stock has declined 8.3% over the past month. However, stock prices are usually driven by a company’s financial performance over the long term, which in this case looks quite promising. Particularly, we will be paying attention to Smith & Nephew's ROE today.

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

Check out our latest analysis for Smith & Nephew

How To Calculate Return On Equity?

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 Smith & Nephew is:

12% = US$600m ÷ US$5.1b (Based on the trailing twelve months to December 2019).

The 'return' is the yearly profit. So, this means that for every £1 of its shareholder's investments, the company generates a profit of £0.12.

What Is The Relationship Between ROE And Earnings Growth?

Thus far, we have learnt that ROE measures how efficiently a company is generating its profits. 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. 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.

A Side By Side comparison of Smith & Nephew's Earnings Growth And 12% ROE

To begin with, Smith & Nephew seems to have a respectable ROE. And on comparing with the industry, we found that the the average industry ROE is similar at 11%. This probably goes some way in explaining Smith & Nephew's moderate 7.9% growth over the past five years amongst other factors.

We then compared Smith & Nephew's net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 36% in the same period, which is a bit concerning.

LSE:SN. Past Earnings Growth July 1st 2020

Earnings growth is a huge factor in stock valuation. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. Doing so will help them establish if the stock's future looks promising or ominous. Is SN. fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is Smith & Nephew Efficiently Re-investing Its Profits?

Smith & Nephew has a healthy combination of a moderate three-year median payout ratio of 45% (or a retention ratio of 55%) and a respectable amount of growth in earnings as we saw above, meaning that the company has been making efficient use of its profits.

Moreover, Smith & Nephew is determined to keep sharing its profits with shareholders which we infer from its long history of paying a dividend for at least ten years. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 37%. However, Smith & Nephew's ROE is predicted to rise to 16% despite there being no anticipated change in its payout ratio.

Summary

In total, we are pretty happy with Smith & Nephew'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 respectable growth in its earnings. Having said that, looking at the current analyst estimates, we found that the company's earnings are expected to gain momentum. 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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