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DS Smith's (LON:SMDS) stock is up by 4.7% over the past month. Given that the markets usually pay for the long-term financial health of a company, we wonder if the current momentum in the share price will keep up, given that the company's financials don't look very promising. Specifically, we decided to study DS Smith's ROE in this article.
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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.
How Is ROE Calculated?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for DS Smith is:
5.1% = UK£182m ÷ UK£3.5b (Based on the trailing twelve months to April 2021).
The 'return' is the yearly profit. That means that for every £1 worth of shareholders' equity, the company generated £0.05 in profit.
What Is The Relationship Between ROE And Earnings Growth?
We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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 DS Smith's Earnings Growth And 5.1% ROE
At first glance, DS Smith's ROE doesn't look very promising. We then compared the company's ROE to the broader industry and were disappointed to see that the ROE is lower than the industry average of 13%. Thus, the low net income growth of 4.5% seen by DS Smith over the past five years could probably be the result of the low ROE.
We then compared DS Smith's net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 5.9% in the same period, which is a bit concerning.
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. Is SMDS fairly valued? This infographic on the company's intrinsic value has everything you need to know.
Is DS Smith Making Efficient Use Of Its Profits?
With a high three-year median payout ratio of 75% (or a retention ratio of 25%), most of DS Smith's profits are being paid to shareholders. This definitely contributes to the low earnings growth seen by the company.
Additionally, DS Smith 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 47% over the next three years. The fact that the company's ROE is expected to rise to 12% over the same period is explained by the drop in the payout ratio.
In total, we would have a hard think before deciding on any investment action concerning DS Smith. As a result of its low ROE and lack of much reinvestment into the business, the company has seen a disappointing earnings growth rate. 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 company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.
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.
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