Shell (LON:SHEL) has had a rough three months with its share price down 5.9%. However, a closer look at its sound financials might cause you to think again. Given that fundamentals usually drive long-term market outcomes, the company is worth looking at. Specifically, we decided to study Shell's ROE in this article.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

Check out our latest analysis for Shell

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 Shell is:

23% = US$44b ÷ US$196b (Based on the trailing twelve months to March 2023).

The 'return' is the profit over the last twelve months. Another way to think of that is that for every £1 worth of equity, the company was able to earn £0.23 in profit.

What Is The Relationship Between ROE And 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 everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.

A Side By Side comparison of Shell's Earnings Growth And 23% ROE

To begin with, Shell has a pretty high ROE which is interesting. Additionally, the company's ROE is higher compared to the industry average of 18% which is quite remarkable. Probably as a result of this, Shell was able to see a decent net income growth of 14% over the last five years.

Next, on comparing with the industry net income growth, we found that Shell's reported growth was lower than the industry growth of 27% in the same period, which is not something we like to see.

Earnings growth is an important metric to consider when valuing a stock. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. What is SHEL worth today? The intrinsic value infographic in our free research report helps visualize whether SHEL is currently mispriced by the market.

Is Shell Making Efficient Use Of Its Profits?

In Shell's case, its respectable earnings growth can probably be explained by its low three-year median payout ratio of 18% (or a retention ratio of 82%), which suggests that the company is investing most of its profits to grow its business.

Additionally, Shell 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. Looking at the current analyst consensus data, we can see that the company's future payout ratio is expected to rise to 33% over the next three years. Therefore, the expected rise in the payout ratio explains why the company's ROE is expected to decline to 11% over the same period.

Conclusion

Overall, we are quite pleased with Shell's performance. Specifically, we like that the company is reinvesting a huge chunk of its profits at a high rate of return. This of course has caused the company to see a good amount of growth in its earnings. 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. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page for the company.

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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