Scales (NZSE:SCL) has seen its stock price rise 11% over the past month, which has caught the attention of investors. However, upon examining the company’s fundamentals, particularly its Return on Equity (ROE), a clearer picture of Scales’ financial health remains elusive.
ROE is a key profitability ratio that measures how efficiently a company generates profit from its shareholders’ equity. The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
For Scales, based on trailing twelve months to June 2024, the ROE is calculated as:
12% = NZ$48 million ÷ NZ$404 million.
This suggests that for every NZ$1 invested by shareholders, Scales generates NZ$0.12 in profit. While this ROE is respectable and on par with the industry average, it doesn’t provide a full picture of Scales’ performance.
The Link Between ROE and Earnings Growth
The relationship between ROE and earnings growth is crucial. Companies with higher ROE and a solid retention of profits generally experience higher growth rates. In Scales’ case, although the ROE is decent, there’s a troubling trend in its net income. Over the last five years, Scales has experienced a 26% decline in net income, which raises questions about the sustainability of its current earnings trajectory.
While Scales’ ROE is steady, its five-year net income decline contrasts sharply with the industry, which experienced a modest 0.8% earnings growth during the same period. This discrepancy signals potential underlying issues such as competitive pressures or the company’s decision to distribute a significant portion of its earnings as dividends.
The Impact of High Dividend Payouts
Scales has been paying out a significant portion of its earnings in dividends, with a high payout ratio of 109% over the past three years. This suggests the company is depleting its resources to maintain dividend payments, which could be unsustainable in the long term. This practice has contributed to the company’s lack of growth and shrinking earnings. The focus on maintaining dividends, even at the cost of reinvesting profits, could potentially hinder Scales’ ability to fund future expansion or reinvest in its business.
A Shift in Dividend Payouts
Despite the current high payout ratio, future projections suggest a reduction in Scales’ payout ratio to 61% over the next three years. However, this expected drop does not necessarily indicate an improvement in the company’s ROE, which is not expected to change significantly.
In conclusion, while Scales’ ROE of 12% is on par with the industry, the company’s declining earnings and high dividend payouts raise concerns about its long-term financial health. Investors should remain cautious, especially given the shrinking net income and the potential unsustainability of its current dividend strategy.
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