Does Warpaint London PLC's (LON:W7L) Weak Fundamentals Mean That The Market Could Correct Its Share Price?

Warpaint London's (LON:W7L) stock is up by a considerable 32% over the past three months. However, in this article, we decided to focus on its weak fundamentals, as long-term financial performance of a business is what ultimatley dictates market outcomes. Specifically, we decided to study Warpaint London's ROE in this article.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Put another way, it reveals the company's success at turning shareholder investments into profits.

See our latest analysis for Warpaint London

How Do You Calculate Return On Equity?

Return on equity 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 Warpaint London is:

0.6% = UK£247k ÷ UK£39m (Based on the trailing twelve months to June 2020).

The 'return' is the profit over the last twelve months. One way to conceptualize this is that for each £1 of shareholders' capital it has, the company made £0.01 in profit.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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 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.

Warpaint London's Earnings Growth And 0.6% ROE

It is hard to argue that Warpaint London's ROE is much good in and of itself. Even when compared to the industry average of 11%, the ROE figure is pretty disappointing. Therefore, it might not be wrong to say that the five year net income decline of 23% seen by Warpaint London was possibly a result of it having a lower ROE. However, there could also be other factors causing the earnings to decline. For instance, the company has a very high payout ratio, or is faced with competitive pressures.

That being said, we compared Warpaint London's performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 23% 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). This then helps them determine if the stock is placed for a bright or bleak future. One good indicator of expected earnings growth is the P/E ratio which determines the price the market is willing to pay for a stock based on its earnings prospects. So, you may want to check if Warpaint London is trading on a high P/E or a low P/E, relative to its industry.

Is Warpaint London Efficiently Re-investing Its Profits?

Warpaint London's declining earnings is not surprising given how the company is spending most of its profits in paying dividends, judging by its three-year median payout ratio of 84% (or a retention ratio of 16%). The business is only left with a small pool of capital to reinvest - A vicious cycle that doesn't benefit the company in the long-run. You can see the 6 risks we have identified for Warpaint London by visiting our risks dashboard for free on our platform here.

Moreover, Warpaint London has been paying dividends for four years, which is a considerable amount of time, suggesting that management must have perceived that the shareholders prefer consistent dividends even though earnings have been shrinking.

Summary

On the whole, Warpaint London's performance is quite a big let-down. As a result of its low ROE and lack of mich reinvestment into the business, the company has seen a disappointing earnings growth rate. So far, we've only made a quick discussion around the company's earnings growth. To gain further insights into Warpaint London's past profit growth, check out this visualization of past earnings, revenue and cash flows.

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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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