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Are Strong Financial Prospects The Force That Is Driving The Momentum In Santos Limited's ASX:STO) Stock?

Santos' (ASX:STO) stock is up by a considerable 9.5% over the past month. Since the market usually pay for a company’s long-term fundamentals, we decided to study the company’s key performance indicators to see if they could be influencing the market. In this article, we decided to focus on Santos' ROE.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

View our latest analysis for Santos

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 Santos is:

10% = US$1.5b ÷ US$14b (Based on the trailing twelve months to June 2022).

The 'return' is the profit over the last twelve months. So, this means that for every A$1 of its shareholder's investments, the company generates a profit of A$0.10.

What Is The Relationship Between ROE And Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. Depending on how much of these profits the company reinvests or "retains", and how effectively it does so, we are then able to assess a company’s earnings growth potential. 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.

Santos' Earnings Growth And 10% ROE

To start with, Santos' ROE looks acceptable. Even so, when compared with the average industry ROE of 21%, we aren't very excited. That being the case, the significant five-year 34% net income growth reported by Santos comes as a pleasant surprise. We reckon that there could be other factors at play here. 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. Bear in mind, the company does have a respectable ROE. It is just that the industry ROE is higher. So this certainly also provides some context to the high earnings growth seen by the company.

As a next step, we compared Santos' net income growth with the industry, and pleasingly, we found that the growth seen by the company is higher than the average industry growth of 12%.

past-earnings-growth
past-earnings-growth

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. This then helps them determine if the stock is placed for a bright or bleak future. If you're wondering about Santos''s valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Santos Making Efficient Use Of Its Profits?

Santos' three-year median payout ratio is a pretty moderate 30%, meaning the company retains 70% of its income. This suggests that its dividend is well covered, and given the high growth we discussed above, it looks like Santos is reinvesting its earnings efficiently.

Moreover, Santos is determined to keep sharing its profits with shareholders which we infer from its long history of paying a dividend for at least ten years. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 36%. Therefore, the company's future ROE is also not expected to change by much with analysts predicting an ROE of 10%.

Conclusion

In total, we are pretty happy with Santos' performance. Particularly, we like that the company is reinvesting heavily into its business at a moderate rate of return. Unsurprisingly, this has led to an impressive earnings growth. Having said that, on studying current analyst estimates, we were concerned to see that while the company has grown its earnings in the past, analysts expect its earnings to shrink in the future. 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.

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.

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