It is hard to get excited after looking at Step One Clothing's (ASX:STP) recent performance, when its stock has declined 1.2% over the past three months. But if you pay close attention, you might find that its key financial indicators look quite decent, which could mean that the stock could potentially rise in the long-term given how markets usually reward more resilient long-term fundamentals. Specifically, we decided to study Step One Clothing's ROE in this article.

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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

See our latest analysis for Step One Clothing

How Is ROE Calculated?

ROE 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 Step One Clothing is:

24% = AU$12m ÷ AU$52m (Based on the trailing twelve months to June 2024).

The 'return' is the yearly profit. Another way to think of that is that for every A$1 worth of equity, the company was able to earn A$0.24 in profit.

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 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.

A Side By Side comparison of Step One Clothing's Earnings Growth And 24% ROE

Firstly, we acknowledge that Step One Clothing has a significantly high ROE. Additionally, the company's ROE is higher compared to the industry average of 17% which is quite remarkable. So, the substantial 47% net income growth seen by Step One Clothing over the past five years isn't overly surprising.

As a next step, we compared Step One Clothing'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 15%.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is Step One Clothing fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Step One Clothing Efficiently Re-investing Its Profits?

Step One Clothing's very high three-year median payout ratio of 136% suggests that the company is paying more to its shareholders than what it is earning. However, this hasn't hampered its ability to grow as we saw earlier. Although, it could be worth keeping an eye on the high payout ratio as that's a huge risk. You can see the 2 risks we have identified for Step One Clothing by visiting our risks dashboard for free on our platform here.

Along with seeing a growth in earnings, Step One Clothing only recently started paying dividends. Its quite possible that the company was looking to impress its shareholders. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 98% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 32%, over the same period.

Summary

Overall, we feel that Step One Clothing certainly does have some positive factors to consider. Namely, its high earnings growth, which was likely due to its high ROE. However, investors could have benefitted even more from the high ROE, had the company been reinvesting more of its earnings. As discussed earlier, the company is retaining hardly any of its profits. With that said, the latest industry analyst forecasts reveal that the company's earnings growth is expected to slow down. 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.