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Most readers would already know that Scales' (NZSE:SCL) stock increased by 7.7% over the past three months. However, its weak financial performance indicators makes us a bit doubtful if that trend could continue. Particularly, we will be paying attention to Scales' 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.
See our latest analysis for Scales
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 Scales is:
6.4% = NZ$25m ÷ NZ$385m (Based on the trailing twelve months to December 2023).
The 'return' is the income the business earned over the last year. That means that for every NZ$1 worth of shareholders' equity, the company generated NZ$0.06 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. Depending on how much of these profits the company reinvests or "retains", and how effectively it does so, we are then able to assess a company’s earnings growth potential. 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.
Scales' Earnings Growth And 6.4% ROE
On the face of it, Scales' ROE is not much to talk about. 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 9.7%. Given the circumstances, the significant decline in net income by 30% seen by Scales over the last five years is not surprising. However, there could also be other factors causing the earnings to decline. For instance, the company has a very high payout ratio, or is faced with competitive pressures.
Next, when we compared with the industry, which has shrunk its earnings at a rate of 5.8% in the same 5-year period, we still found Scales' performance to be quite bleak, because the company has been shrinking its earnings faster than the industry.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. 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.