Red 5 Limited's (ASX:RED) Stock Has Shown Weakness Lately But Financial Prospects Look Decent: Is The Market Wrong?

It is hard to get excited after looking at Red 5's (ASX:RED) recent performance, when its stock has declined 24% over the past three months. However, the company's fundamentals look pretty decent, and long-term financials are usually aligned with future market price movements. Specifically, we decided to study Red 5's ROE in this article.

ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

See our latest analysis for Red 5

How Do You Calculate Return On Equity?

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 Red 5 is:

2.3% = AU$4.5m ÷ AU$196m (Based on the trailing twelve months to June 2020).

The 'return' refers to a company's earnings over the last year. That means that for every A$1 worth of shareholders' equity, the company generated 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. 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.

Red 5's Earnings Growth And 2.3% ROE

It is quite clear that Red 5's ROE is rather low. Even when compared to the industry average of 13%, the ROE figure is pretty disappointing. In spite of this, Red 5 was able to grow its net income considerably, at a rate of 32% in the last five years. Therefore, there could be other reasons behind this growth. Such as - high earnings retention or an efficient management in place.

We then performed a comparison between Red 5's net income growth with the industry, which revealed that the company's growth is similar to the average industry growth of 32% in the same period.

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. Is Red 5 fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Red 5 Making Efficient Use Of Its Profits?

Conclusion

In total, it does look like Red 5 has some positive aspects to its business. With a high rate of reinvestment, albeit at a low ROE, the company has managed to see a considerable growth in its earnings. Having said that, looking at the current analyst estimates, we found that the company's earnings are expected to gain momentum. 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.

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This article by Simply Wall St is general in nature. 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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