Most readers would already know that Smartgroup's (ASX:SIQ) stock increased by 4.5% over the past three months. Given that stock prices are usually aligned with a company's financial performance in the long-term, we decided to investigate if the company's decent financials had a hand to play in the recent price move. In this article, we decided to focus on Smartgroup's  ROE.

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. Put another way, it reveals the company's success at turning shareholder investments into profits.

See our latest analysis for Smartgroup

How Do You 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 Smartgroup is:

24% = AU$57m ÷ AU$232m (Based on the trailing twelve months to June 2023).

The 'return' is the income the business earned over the last year. So, this means that for every A$1 of its shareholder's investments, the company generates a profit of A$0.24.

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. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. 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 Smartgroup's Earnings Growth And 24% ROE

Firstly, we acknowledge that Smartgroup has a significantly high ROE. Additionally, the company's ROE is higher compared to the industry average of 16% which is quite remarkable. However, we are curious as to how the high returns still resulted in a flat growth for Smartgroup in the past five years. Based on this, we feel that there might be other reasons which haven't been discussed so far in this article that could be hampering the company's growth. These include low earnings retention or poor allocation of capital



Next, on comparing with the industry net income growth, we found that Smartgroup's reported growth was lower than the industry growth of 8.7% over the last few years, which is not something we like to see. past-earnings-growth

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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. What is SIQ worth today? The  intrinsic value infographic in our free research report  helps visualize whether SIQ is currently mispriced by the market.

Is Smartgroup Making Efficient Use Of Its Profits?

Smartgroup has a high three-year median payout ratio of 80% (or a retention ratio of 20%), meaning that the company is paying most of its profits as dividends to its shareholders. This does go some way in explaining why there's been no growth in its earnings.

Moreover, Smartgroup has been paying dividends for nine years, which is a considerable amount of time, suggesting that management must have perceived that the shareholders prefer dividends over earnings growth. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 88% of its profits over the next three years. Still, forecasts suggest that Smartgroup's future ROE will rise to 30% even though the the company's payout ratio is not expected to change by much.

Summary

Overall, we feel that Smartgroup certainly does have some positive factors to consider. Yet, the low earnings growth is a bit concerning, especially given that the company has a high rate of return. Investors could have benefitted from the high ROE, had the company been reinvesting more of its earnings. As discussed earlier, the company is retaining a small portion of its profits. 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 freereport on analyst forecasts for the company to find out more.

Have feedback on this article? Concerned about the content?Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.