With its stock down 9.2% over the past three months, it is easy to disregard Pacific Smiles Group (ASX:PSQ). 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. Long-term fundamentals are usually what drive market outcomes, so it's worth paying close attention. Specifically, we decided to study Pacific Smiles Group's 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.

View our latest analysis for Pacific Smiles Group

How Do You Calculate Return On Equity?

ROE 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 Pacific Smiles Group is:

26% = AU$12m ÷ AU$47m (Based on the trailing twelve months to December 2020).

The 'return' is the profit over the last twelve months. Another way to think of that is that for every A$1 worth of equity, the company was able to earn A$0.26 in profit.

What Is The Relationship Between ROE And Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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.

Pacific Smiles Group's Earnings Growth And 26% ROE

Firstly, we acknowledge that Pacific Smiles Group has a significantly high ROE. Additionally, the company's ROE is higher compared to the industry average of 11% which is quite remarkable. Needless to say, we are quite surprised to see that Pacific Smiles Group's net income shrunk at a rate of 3.1% over the past five years. Based on this, we feel that there might be other reasons which haven't been discussed so far in this article that could be hampering the company's growth. Such as, the company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.

However, when we compared Pacific Smiles Group's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 2.2% in the same period. This is quite worrisome.

Earnings growth is a huge factor in stock valuation. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). This then helps them determine if the stock is placed for a bright or bleak future. Is PSQ fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is Pacific Smiles Group Making Efficient Use Of Its Profits?

With a three-year median payout ratio as high as 106%,Pacific Smiles Group's shrinking earnings don't come as a surprise as the company is paying a dividend which is beyond its means. Paying a dividend higher than reported profits is not a sustainable move. Our risks dashboard should have the 2 risks we have identified for Pacific Smiles Group.

Additionally, Pacific Smiles Group has paid dividends over a period of six years, which means that the company's management is rather focused on keeping up its dividend payments, regardless of the shrinking earnings. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 69% over the next three years. Regardless, the ROE is not expected to change much for the company despite the lower expected payout ratio.

Summary

Overall, we have mixed feelings about Pacific Smiles Group. While the company does have a high rate of return, its low earnings retention is probably what's hampering its earnings growth. 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.

This article by Simply Wall St is general in nature. 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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