Yahoo Finance Are Smith & Nephew plc's (LON:SN.) Mixed Financials Driving The Negative Sentiment?
Smith & Nephew (LON:SN.) has had a rough three months with its share price down 14%. We, however decided to study the company's financials to determine if they have got anything to do with the price decline. Long-term fundamentals are usually what drive market outcomes, so it's worth paying close attention. 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 short, ROE shows the profit each dollar generates with respect to its shareholder investments.
Check out our latest analysis for Smith & Nephew
How Do You Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Smith & Nephew is:
8.5% = US$448m ÷ US$5.3b (Based on the trailing twelve months to December 2020).
The 'return' is the profit over the last twelve months. That means that for every £1 worth of shareholders' equity, the company generated £0.08 in profit.
Why Is ROE Important For 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. 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 8.5% ROE
At first glance, Smith & Nephew's ROE doesn't look very promising. Yet, a closer study shows that the company's ROE is similar to the industry average of 7.6%. But Smith & Nephew saw a five year net income decline of 2.4% over the past five years. Remember, the company's ROE is a bit low to begin with. Hence, this goes some way in explaining the shrinking earnings.
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 30% 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. This then helps them determine if the stock is placed for a bright or bleak future. Has the market priced in the future outlook for SN.? You can find out in our latest intrinsic value infographic research report.
Is Smith & Nephew Using Its Retained Earnings Effectively?
In spite of a normal three-year median payout ratio of 47% (that is, a retention ratio of 53%), the fact that Smith & Nephew's earnings have shrunk is quite puzzling. It looks like there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.
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. Based on the latest analysts' estimates, we found that the company's future payout ratio over the next three years is expected to hold steady at 40%. Still, forecasts suggest that Smith & Nephew's future ROE will rise to 15% even though the the company's payout ratio is not expected to change by much.
Conclusion
On the whole, we feel that the performance shown by Smith & Nephew can be open to many interpretations. While the company does have a high rate of profit retention, its low rate of return is probably hampering its earnings growth. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. 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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