SAP (ETR:SAP) has had a great run on the share market with its stock up by a significant 18% over the last three months. But the company's key financial indicators appear to be differing across the board and that makes us question whether or not the company's current share price momentum can be maintained. Particularly, we will be paying attention to SAP's ROE today.

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

Check out our latest analysis for SAP

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 SAP is:

8.3% = €3.6b ÷ €43b (Based on the trailing twelve months to December 2023).

The 'return' is the yearly profit. One way to conceptualize this is that for each €1 of shareholders' capital it has, the company made €0.08 in profit.

Why Is ROE Important For Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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.

SAP's Earnings Growth And 8.3% ROE

When you first look at it, SAP's ROE doesn't look that attractive. A quick further study shows that the company's ROE doesn't compare favorably to the industry average of 19% either. Given the circumstances, the significant decline in net income by 3.8% seen by SAP over the last five years is not surprising. We believe that there also might be other aspects that are negatively influencing the company's earnings prospects. For example, it is possible that the business has allocated capital poorly or that the company has a very high payout ratio.

However, when we compared SAP's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 18% in the same period. This is quite worrisome.

Earnings growth is an important metric to consider when valuing a stock. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). Doing so will help them establish if the stock's future looks promising or ominous. Has the market priced in the future outlook for SAP? You can find out in our latest intrinsic value infographic research report.

Is SAP Making Efficient Use Of Its Profits?

Despite having a normal three-year median payout ratio of 49% (where it is retaining 51% of its profits), SAP has seen a decline in earnings as we saw above. 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, SAP 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. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 36% over the next three years. As a result, the expected drop in SAP's payout ratio explains the anticipated rise in the company's future ROE to 17%, over the same period.

Conclusion

Overall, we have mixed feelings about SAP. 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. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.

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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.