Yahoo Finance Smith & Nephew plc (LON:SN.) Stock's Been Sliding But Fundamentals Look Decent: Will The Market Correct The Share Price In The Future?
It is hard to get excited after looking at Smith & Nephew's (LON:SN.) recent performance, when its stock has declined 6.1% over the past three months. But if you pay close attention, you might find that its key financial indicators look quite decent, which could mean that the stock could potentially rise in the long-term given how markets usually reward more resilient long-term fundamentals. 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 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 Smith & Nephew
How Do You Calculate Return On Equity?
ROE 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:
9.2% = US$496m ÷ US$5.4b (Based on the trailing twelve months to July 2022).
The 'return' is the amount earned after tax 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 £0.09 in profit.
What Is The Relationship Between ROE And Earnings Growth?
Thus far, we have learned 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. 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.
Smith & Nephew's Earnings Growth And 9.2% ROE
To start with, Smith & Nephew's ROE looks acceptable. And on comparing with the industry, we found that the the average industry ROE is similar at 9.2%. However, while Smith & Nephew has a pretty respectable ROE, its five year net income decline rate was 12% . So, there might be some other aspects that could explain this. For example, it could be that the company has a high payout ratio or the business has allocated capital poorly, for instance.
However, when we compared Smith & Nephew's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 1.0% in the same period. This is quite worrisome.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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. 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 Making Efficient Use Of Its Profits?
With a high three-year median payout ratio of 65% (implying that 35% of the profits are retained), most of Smith & Nephew's profits are being paid to shareholders, which explains the company's shrinking earnings. With only very little left to reinvest into the business, growth in earnings is far from likely. You can see the 2 risks we have identified for Smith & Nephew by visiting our risks dashboard for free on our platform here.
Additionally, Smith & Nephew 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. The fact that the company's ROE is expected to rise to 15% over the same period is explained by the drop in the payout ratio.
Summary
In total, it does look like Smith & Nephew has some positive aspects to its business. 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. 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 latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.
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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.
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