Are Spirax-Sarco Engineering plc's (LON:SPX) Fundamentals Good Enough to Warrant Buying Given The Stock's Recent Weakness?

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editorial-team@simplywallst.com (Simply Wall St)

Sun, Oct 1, 2023, 1:14 AM 4 min read

Spirax-Sarco Engineering (LON:SPX) has had a rough three months with its share price down 7.9%. However, stock prices are usually driven by a company’s financials over the long term, which in this case look pretty respectable. In this article, we decided to focus on Spirax-Sarco Engineering'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. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

View our latest analysis for Spirax-Sarco Engineering

How Is ROE Calculated?

The formula for ROE is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Spirax-Sarco Engineering is:

19% = UK£211m ÷ UK£1.1b (Based on the trailing twelve months to June 2023).

The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each £1 of shareholders' capital it has, the company made £0.19 in profit.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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 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.

A Side By Side comparison of Spirax-Sarco Engineering's Earnings Growth And 19% ROE

At first glance, Spirax-Sarco Engineering seems to have a decent ROE. Further, the company's ROE compares quite favorably to the industry average of 14%. Despite this, Spirax-Sarco Engineering's five year net income growth was quite low averaging at only 3.2%. This is generally not the case as when a company has a high rate of return it should usually also have a high earnings growth rate. Such a scenario is likely to take place when a company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.

As a next step, we compared Spirax-Sarco Engineering's net income growth with the industry and were disappointed to see that the company's growth is lower than the industry average growth of 7.1% in the same period.

past-earnings-growth — LSE:SPX Past Earnings Growth October 1st 2023

Earnings growth is an important metric to consider when valuing a stock. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. Doing so will help them establish if the stock's future looks promising or ominous. 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 Spirax-Sarco Engineering is trading on a high P/E or a low P/E, relative to its industry.

Is Spirax-Sarco Engineering Efficiently Re-investing Its Profits?

Despite having a moderate three-year median payout ratio of 48% (implying that the company retains the remaining 52% of its income), Spirax-Sarco Engineering's earnings growth was quite low. So there could be some other explanation in that regard. For instance, the company's business may be deteriorating.

Additionally, Spirax-Sarco Engineering 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. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 43%. Accordingly, forecasts suggest that Spirax-Sarco Engineering's future ROE will be 21% which is again, similar to the current ROE.

Summary

On the whole, we do feel that Spirax-Sarco Engineering has some positive attributes. However, given the high ROE and high profit retention, we would expect the company to be delivering strong earnings growth, but that isn't the case here. This suggests that there might be some external threat to the business, that's hampering its growth. That being so, the latest analyst forecasts show that the company will continue to see an expansion in its earnings. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.

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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.