With its stock down 8.1% over the past three months, it is easy to disregard Standard Motor Products (NYSE:SMP). It seems that the market might have completely ignored the positive aspects of the company's fundamentals and decided to weigh-in more on the negative aspects. Stock prices are usually driven by a company's financial performance over the long term, and therefore we decided to pay more attention to the company's financial performance. Specifically, we decided to study Standard Motor Products' ROE in this article.

ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. Put another way, it reveals the company's success at turning shareholder investments into profits.

How Do You Calculate Return On Equity?

The formula for return on equity is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Standard Motor Products is:

9.6% = US$62m ÷ US$653m (Based on the trailing twelve months to September 2024).

The 'return' is the income the business earned over the last year. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.10.

What Has ROE Got To Do With Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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 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.

Standard Motor Products' Earnings Growth And 9.6% ROE

When you first look at it, Standard Motor Products' ROE doesn't look that attractive. Yet, a closer study shows that the company's ROE is similar to the industry average of 11%. But Standard Motor Products saw a five year net income decline of 3.7% over the past five years. Bear in mind, the company does have a slightly low ROE. Hence, this goes some way in explaining the shrinking earnings.

However, when we compared Standard Motor Products' growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 14% in the same period. This is quite worrisome.

Earnings growth is a huge factor in stock valuation. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. One good indicator of expected earnings growth is the P/E ratio which determines the price the market is willing to pay for a stock based on its earnings prospects. So, you may want to check if Standard Motor Products is trading on a high P/E or a low P/E, relative to its industry.

Is Standard Motor Products Efficiently Re-investing Its Profits?

Despite having a normal three-year median payout ratio of 37% (where it is retaining 63% of its profits), Standard Motor Products has seen a decline in earnings as we saw above. So there could be some other explanations in that regard. For instance, the company's business may be deteriorating.

Additionally, Standard Motor Products has paid dividends over a period of at least ten years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth.

Summary

On the whole, we feel that the performance shown by Standard Motor Products can be open to many interpretations. While the company does have a high rate of profit retention, its low rate of return is probably hampering its earnings growth. Wrapping up, we would proceed with caution with this company and one way of doing that would be to look at the risk profile of the business. To know the 3 risks we have identified for Standard Motor Products visit our risks dashboard for free.

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.