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Servcorp Limited (ASX:SRV) Stock's On A Decline: Are Poor Fundamentals The Cause?

·4-min read

It is hard to get excited after looking at Servcorp's (ASX:SRV) recent performance, when its stock has declined 14% over the past three months. To decide if this trend could continue, we decided to look at its weak fundamentals as they shape the long-term market trends. Particularly, we will be paying attention to Servcorp's ROE today.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Put another way, it reveals the company's success at turning shareholder investments into profits.

View our latest analysis for Servcorp

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 Servcorp is:

9.8% = AU$20m ÷ AU$203m (Based on the trailing twelve months to December 2021).

The 'return' refers to a company's earnings over the last year. That means that for every A$1 worth of shareholders' equity, the company generated A$0.10 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. 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.

Servcorp's Earnings Growth And 9.8% ROE

When you first look at it, Servcorp's ROE doesn't look that attractive. However, the fact that the company's ROE is higher than the average industry ROE of 7.4%, is definitely interesting. But then again, seeing that Servcorp's net income shrunk at a rate of 18% in the past five years, makes us think again. Remember, the company's ROE is a bit low to begin with, just that it is higher than the industry average. Hence, this goes some way in explaining the shrinking earnings.

Furthermore, even when compared to the industry, which has been shrinking its earnings at a rate 10% in the same period, we found that Servcorp's performance is pretty disappointing, as it suggests that the company has been shrunk its earnings at a rate faster than the industry.

past-earnings-growth
past-earnings-growth

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. If you're wondering about Servcorp's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Servcorp Using Its Retained Earnings Effectively?

Servcorp's high three-year median payout ratio of 111% suggests that the company is depleting its resources to keep up its dividend payments, and this shows in its shrinking earnings. Its usually very hard to sustain dividend payments that are higher than reported profits.

In addition, Servcorp 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. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 66% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 15%, over the same period.

Conclusion

On the whole, Servcorp's performance is quite a big let-down. The company has shown a disappointing growth in its earnings as a result of it retaining little to almost none of its profits. So, the decent ROE it does have, is not much useful to investors given that the company is reinvesting very little into its business. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.

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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