With its stock down 22% over the past three months, it is easy to disregard Red 5 (ASX:RED). But if you pay close attention, you might find that its key financial indicators look quite decent, which could mean that the stock could potentially rise in the long-term given how markets usually reward more resilient long-term fundamentals. In this article, we decided to focus on Red 5's 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. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.
Check out our latest analysis for Red 5
How Do You Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Red 5 is:
2.3% = AU$4.5m ÷ AU$196m (Based on the trailing twelve months to June 2020).
The 'return' is the amount earned after tax 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$0.02 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. 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. 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.
Red 5's Earnings Growth And 2.3% ROE
It is quite clear that Red 5's ROE is rather low. Even compared to the average industry ROE of 13%, the company's ROE is quite dismal. In spite of this, Red 5 was able to grow its net income considerably, at a rate of 32% in the last five years. We reckon that there could be other factors at play here. For instance, the company has a low payout ratio or is being managed efficiently.
Next, on comparing Red 5's net income growth with the industry, we found that the company's reported growth is similar to the industry average growth rate of 32% in the same period.
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. Is Red 5 fairly valued compared to other companies? These 3 valuation measures might help you decide.