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Could The Market Be Wrong About Spirent Communications plc (LON:SPT) Given Its Attractive Financial Prospects?

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With its stock down 9.0% over the past three months, it is easy to disregard Spirent Communications (LON:SPT). But if you pay close attention, you might gather that its strong financials could mean that the stock could potentially see an increase in value in the long-term, given how markets usually reward companies with good financial health. In this article, we decided to focus on Spirent Communications' ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

See our latest analysis for Spirent Communications

How Is ROE Calculated?

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 Spirent Communications is:

20% = US$82m ÷ US$411m (Based on the trailing twelve months to June 2021).

The 'return' is the yearly profit. That means that for every £1 worth of shareholders' equity, the company generated £0.20 in profit.

Why Is ROE Important For Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don’t share these attributes.

Spirent Communications' Earnings Growth And 20% ROE

To begin with, Spirent Communications seems to have a respectable ROE. Further, the company's ROE compares quite favorably to the industry average of 14%. This probably laid the ground for Spirent Communications' significant 49% net income growth seen over the past five years. We believe that there might also be other aspects that are positively influencing the company's earnings growth. For example, it is possible that the company's management has made some good strategic decisions, or that the company has a low payout ratio.

Next, on comparing with the industry net income growth, we found that Spirent Communications' growth is quite high when compared to the industry average growth of 29% in the same period, which is great to see.

past-earnings-growth
past-earnings-growth

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. Has the market priced in the future outlook for SPT? You can find out in our latest intrinsic value infographic research report.

Is Spirent Communications Using Its Retained Earnings Effectively?

Spirent Communications' three-year median payout ratio is a pretty moderate 45%, meaning the company retains 55% of its income. This suggests that its dividend is well covered, and given the high growth we discussed above, it looks like Spirent Communications is reinvesting its earnings efficiently.

Additionally, Spirent Communications has paid dividends over a period of at least ten years which means that the company is pretty serious about sharing its profits with shareholders. Based on the latest analysts' estimates, we found that the company's future payout ratio over the next three years is expected to hold steady at 41%. Therefore, the company's future ROE is also not expected to change by much with analysts predicting an ROE of 21%.

Summary

On the whole, we feel that Spirent Communications' performance has been quite good. Particularly, we like that the company is reinvesting heavily into its business, and at a high rate of return. Unsurprisingly, this has led to an impressive earnings growth. Having said that, the company's earnings growth is expected to slow down, as forecasted in the current analyst estimates. 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. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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