Spectra Systems' (LON:SPSC) stock is up by a considerable 38% over the past three months. Since the market usually pay for a company’s long-term fundamentals, we decided to study the company’s key performance indicators to see if they could be influencing the market. In this article, we decided to focus on Spectra Systems' 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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
How Is ROE Calculated?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Spectra Systems is:
18% = US$4.2m ÷ US$24m (Based on the trailing twelve months to June 2020).
The 'return' is the amount earned after tax over the last twelve months. Another way to think of that is that for every £1 worth of equity, the company was able to earn £0.18 in profit.
What Has ROE Got To Do With Earnings Growth?
So far, we've learned that ROE is a measure of a company's profitability. 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. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don’t share these attributes.
A Side By Side comparison of Spectra Systems' Earnings Growth And 18% ROE
At first glance, Spectra Systems seems to have a decent ROE. Especially when compared to the industry average of 8.0% the company's ROE looks pretty impressive. This certainly adds some context to Spectra Systems' exceptional 37% net income growth seen over the past five years. We reckon that there could also be other factors at play here. For example, it is possible that the company's management has made some good strategic decisions, or that the company has a low payout ratio.
As a next step, we compared Spectra Systems' 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 17%.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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 Spectra Systems is trading on a high P/E or a low P/E, relative to its industry.
Is Spectra Systems Using Its Retained Earnings Effectively?
Spectra Systems' significant three-year median payout ratio of 75% (where it is retaining only 25% of its income) suggests that the company has been able to achieve a high growth in earnings despite returning most of its income to shareholders.
Besides, Spectra Systems has been paying dividends over a period of four years. This shows that the company is committed to sharing profits with its shareholders.
In total, we are pretty happy with Spectra Systems' performance. Especially the high ROE, Which has contributed to the impressive growth seen in earnings. Despite the company reinvesting only a small portion of its profits, it still has managed to grow its earnings so that is appreciable. Up till now, we've only made a short study of the company's growth data. To gain further insights into Spectra Systems' past profit growth, check out this visualization of past earnings, revenue and cash flows.
This article by Simply Wall St is general in nature. 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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