With its stock down 15% over the past month, it is easy to disregard Smith & Nephew (LON:SN.). Given that stock prices are usually driven by a company’s fundamentals over the long term, which in this case look pretty weak, we decided to study the company's key financial indicators. Particularly, we will be paying attention to Smith & Nephew's 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.

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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 Smith & Nephew is:

7.8% = US$412m ÷ US$5.3b (Based on the trailing twelve months to December 2024).

The 'return' is the profit 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 £0.08 in profit.

Check out our latest analysis for Smith & Nephew

Why Is ROE Important For 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.

Smith & Nephew's Earnings Growth And 7.8% ROE

When you first look at it, Smith & Nephew's ROE doesn't look that attractive. Yet, a closer study shows that the company's ROE is similar to the industry average of 6.8%. But Smith & Nephew saw a five year net income decline of 13% over the past five years. Bear in mind, the company does have a slightly low ROE. So that's what might be causing earnings growth to shrink.

That being said, we compared Smith & Nephew's performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 3.8% in the same 5-year period.

Earnings growth is an important metric to consider when valuing a stock. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. Doing so will help them establish if the stock's future looks promising or ominous. Is SN. fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is Smith & Nephew Making Efficient Use Of Its Profits?

Smith & Nephew's high three-year median payout ratio of 107% suggests that the company is depleting its resources to keep up its dividend payments, and this shows in its shrinking earnings. Paying a dividend higher than reported profits is not a sustainable move. Our risks dashboard should have the 2 risks we have identified for Smith & Nephew.

In addition, Smith & Nephew 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. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 40% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 17%, over the same period.

Conclusion

On the whole, Smith & Nephew's performance is quite a big let-down. Particularly, its ROE is a huge disappointment, not to mention its lack of proper reinvestment into the business. As a result its earnings growth has also been quite disappointing. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. 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.