Is Scott Technology Limited's (NZSE:SCT) Stock On A Downtrend As A Result Of Its Poor Financials?

With its stock down 3.7% over the past month, it is easy to disregard Scott Technology (NZSE:SCT). We decided to study the company's financials to determine if the downtrend will continue as the long-term performance of a company usually dictates market outcomes. In this article, we decided to focus on Scott Technology's ROE.

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

Check out our latest analysis for Scott Technology

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 Scott Technology is:

9.2% = NZ$9.6m ÷ NZ$104m (Based on the trailing twelve months to February 2022).

The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each NZ$1 of shareholders' capital it has, the company made NZ$0.09 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. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. 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 Scott Technology's Earnings Growth And 9.2% ROE

On the face of it, Scott Technology's ROE is not much to talk about. Yet, a closer study shows that the company's ROE is similar to the industry average of 11%. Having said that, Scott Technology's five year net income decline rate was 22%. Bear in mind, the company does have a slightly low ROE. Therefore, the decline in earnings could also be the result of this.

So, as a next step, we compared Scott Technology's performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 7.6% in the same period.

Earnings growth is a huge factor in stock valuation. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). 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 Scott Technology is trading on a high P/E or a low P/E, relative to its industry.

Is Scott Technology Making Efficient Use Of Its Profits?

With a high three-year median payout ratio of 57% (implying that 43% of the profits are retained), most of Scott Technology's profits are being paid to shareholders, which explains the company's shrinking earnings. The business is only left with a small pool of capital to reinvest - A vicious cycle that doesn't benefit the company in the long-run.

In addition, Scott Technology has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth.

Conclusion

In total, we would have a hard think before deciding on any investment action concerning Scott Technology. The company has seen a lack of earnings growth as a result of retaining very little profits and whatever little it does retain, is being reinvested at a very low rate of return. Until now, we have only just grazed the surface of the company's past performance by looking at the company's fundamentals. You can do your own research on Scott Technology and see how it has performed in the past by looking at this FREE detailed graph of past earnings, revenue and cash flows.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.

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