With its stock down 12% over the past month, it is easy to disregard Santos (ASX:STO). However, stock prices are usually driven by a company’s financial performance over the long term, which in this case looks quite promising. Particularly, we will be paying attention to Santos' 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.
How Do You Calculate Return On Equity?
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 Santos is:
12% = US$1.7b ÷ US$15b (Based on the trailing twelve months to June 2023).
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$0.12 in profit.
What Is The Relationship Between ROE And Earnings Growth?
Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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.
Santos' Earnings Growth And 12% ROE
To start with, Santos' ROE looks acceptable. Be that as it may, the company's ROE is still quite lower than the industry average of 18%. That being the case, the significant five-year 34% net income growth reported by Santos comes as a pleasant surprise. We believe that there might be other aspects that are positively influencing the company's earnings growth. For instance, the company has a low payout ratio or is being managed efficiently. Bear in mind, the company does have a respectable ROE. It is just that the industry ROE is higher. So this also does lend some color to the high earnings growth seen by the company.
Next, on comparing Santos' net income growth with the industry, we found that the company's reported growth is similar to the industry average growth rate of 33% over the last few years.
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. Doing so will help them establish if the stock's future looks promising or ominous. What is STO worth today? The intrinsic value infographic in our free research report helps visualize whether STO is currently mispriced by the market.
Is Santos Efficiently Re-investing Its Profits?
Santos' three-year median payout ratio is a pretty moderate 35%, meaning the company retains 65% of its income. By the looks of it, the dividend is well covered and Santos is reinvesting its profits efficiently as evidenced by its exceptional growth which we discussed above.
Moreover, Santos is determined to keep sharing its profits with shareholders which we infer from its long history of paying a dividend for at least ten years. Our latest analyst data shows that the future payout ratio of the company is expected to rise to 44% over the next three years. Regardless, the ROE is not expected to change much for the company despite the higher expected payout ratio.
On the whole, we feel that Santos' performance has been quite good. Specifically, we like that it has been reinvesting a high portion of its profits at a moderate rate of return, resulting in earnings expansion. 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.