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Schaffer (ASX:SFC) has had a great run on the share market with its stock up by a significant 21% over the last three months. Given the company's impressive performance, we decided to study its financial indicators more closely as a company's financial health over the long-term usually dictates market outcomes. Particularly, we will be paying attention to Schaffer's ROE today.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.
View our latest analysis for Schaffer
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 Schaffer is:
22% = AU$27m ÷ AU$124m (Based on the trailing twelve months to June 2020).
The 'return' is the income the business earned over the last year. That means that for every A$1 worth of shareholders' equity, the company generated A$0.22 in profit.
What Has ROE Got To Do With 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.
Schaffer's Earnings Growth And 22% ROE
To begin with, Schaffer seems to have a respectable ROE. Further, the company's ROE compares quite favorably to the industry average of 16%. This probably laid the ground for Schaffer's significant 38% net income growth seen over the past five years. However, there could also be other causes behind this growth. Such as - high earnings retention or an efficient management in place.
As a next step, we compared Schaffer's net income growth with the industry, and pleasingly, we found that the growth seen by the company is higher than the average industry growth of 13%.
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. Doing so will help them establish if the stock's future looks promising or ominous. If you're wondering about Schaffer's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.