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Most readers would already be aware that Scales' (NZSE:SCL) stock increased significantly by 11% over the past month. However, we decided to pay attention to the company's fundamentals which don't appear to give a clear sign about the company's financial health. In this article, we decided to focus on Scales' ROE.
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.
See our latest analysis for Scales
How Is ROE Calculated?
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 Scales is:
12% = NZ$48m ÷ NZ$404m (Based on the trailing twelve months to June 2024).
The 'return' is the yearly profit. So, this means that for every NZ$1 of its shareholder's investments, the company generates a profit of NZ$0.12.
What Has ROE Got To Do With 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. Assuming everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.
Scales' Earnings Growth And 12% ROE
To start with, Scales' ROE looks acceptable. Further, the company's ROE is similar to the industry average of 12%. However, while Scales has a pretty respectable ROE, its five year net income decline rate was 26% . We reckon that there could be some other factors at play here that are preventing the company's growth. Such as, the company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.
However, when we compared Scales' growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 0.8% 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. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). This then helps them determine if the stock is placed for a bright or bleak future. One good indicator of expected earnings growth is the P/E ratio which determines the price the market is willing to pay for a stock based on its earnings prospects. So, you may want to check if Scales is trading on a high P/E or a low P/E, relative to its industry.