With its stock down 2.2% over the past month, it is easy to disregard Smartgroup (ASX:SIQ). 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 Smartgroup's ROE.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. 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 Smartgroup

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 Smartgroup is:

28% = AU$67m ÷ AU$239m (Based on the trailing twelve months to June 2024).

The 'return' refers to a company's earnings over the last year. Another way to think of that is that for every A$1 worth of equity, the company was able to earn A$0.28 in profit.

What Is The Relationship Between ROE And 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 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.

Smartgroup's Earnings Growth And 28% ROE

Firstly, we acknowledge that Smartgroup has a significantly high ROE. Second, a comparison with the average ROE reported by the industry of 16% also doesn't go unnoticed by us. Yet, Smartgroup has posted measly growth of 3.6% over the past five years. 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. A few likely reasons why this could happen is that the company could have a high payout ratio or the business has allocated capital poorly, for instance.

Next, on comparing Smartgroup's net income growth with the industry, we found that the company's reported growth is similar to the industry average growth rate of 3.6% over the last few years.

Earnings growth is an important metric to consider when valuing a stock. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. 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 Smartgroup is trading on a high P/E or a low P/E, relative to its industry.

Is Smartgroup Efficiently Re-investing Its Profits?

With a high three-year median payout ratio of 71% (or a retention ratio of 29%), most of Smartgroup's profits are being paid to shareholders. This definitely contributes to the low earnings growth seen by the company.

Moreover, Smartgroup has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over 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 75%. As a result, Smartgroup's ROE is not expected to change by much either, which we inferred from the analyst estimate of 30% for future ROE.

Summary

In total, it does look like Smartgroup has some positive aspects to its business. Its earnings growth is decent, and the high ROE does contribute to that growth. However, investors could have benefitted even more from the high ROE, had the company been reinvesting more of its earnings. Having said that, looking at the current analyst estimates, we found that the company's earnings are expected to gain momentum. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.

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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.