Most readers would already be aware that Stepan's (NYSE:SCL) stock increased significantly by 16% over the past three months. However, we wonder if the company's inconsistent financials would have any adverse impact on the current share price momentum. In this article, we decided to focus on Stepan's ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors' money. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

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 Stepan is:

4.3% = US$52m ÷ US$1.2b (Based on the trailing twelve months to September 2023).

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 $0.04 in profit.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. 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.

A Side By Side comparison of Stepan's Earnings Growth And 4.3% ROE

At first glance, Stepan's ROE doesn't look very promising. A quick further study shows that the company's ROE doesn't compare favorably to the industry average of 13% either. Thus, the low net income growth of 2.4% seen by Stepan over the past five years could probably be the result of the low ROE.

We then compared Stepan's net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 12% in the same 5-year period, which is a bit concerning.

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. This then helps them determine if the stock is placed for a bright or bleak future. Has the market priced in the future outlook for SCL? You can find out in our latest intrinsic value infographic research report.

Is Stepan Efficiently Re-investing Its Profits?

Stepan has a low three-year median payout ratio of 21% (meaning, the company keeps the remaining 79% of profits) which means that the company is retaining more of its earnings. However, the low earnings growth number doesn't reflect this fact. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.

In addition, Stepan 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. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to rise to 33% over the next three years.

Summary

On the whole, we feel that the performance shown by Stepan can be open to many interpretations. Even though it appears to be retaining most of its profits, given the low ROE, investors may not be benefitting from all that reinvestment after all. The low earnings growth suggests our theory correct. That being so, the latest analyst forecasts show that the company will continue to see an expansion in its earnings. 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.