Redde Northgate plc (LON:REDD) Stock Is Going Strong But Fundamentals Look Uncertain: What Lies Ahead ?

Redde Northgate's (LON:REDD) stock is up by a considerable 19% over the past month. 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 Redde Northgate's ROE today.

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. Put another way, it reveals the company's success at turning shareholder investments into profits.

See our latest analysis for Redde Northgate

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 Redde Northgate is:

11% = UK£100m ÷ UK£933m (Based on the trailing twelve months to October 2021).

The 'return' is the yearly profit. So, this means that for every £1 of its shareholder's investments, the company generates a profit of £0.11.

What Is The Relationship Between ROE And Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. 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.

Redde Northgate's Earnings Growth And 11% ROE

To start with, Redde Northgate's ROE looks acceptable. Be that as it may, the company's ROE is still quite lower than the industry average of 19%. Additionally, the flat earnings seen by Redde Northgate over the past five years doesn't paint a very bright picture. Bear in mind, the company does have a respectable level of ROE. It is just that the industry ROE is higher. Hence there might be some other aspects that are causing the flat growth in earnings. Such as, the company pays out a huge portion of its earnings as dividends, or is faced with competitve pressures.

As a next step, we compared Redde Northgate's performance with the industry and discovered the industry has shrunk at a rate of 15% in the same period meaning that the company has been shrinking its earnings at a rate lower than the industry. This does appease the negative sentiment around the company to a certain extent.

Earnings growth is a huge factor in stock valuation. 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. Has the market priced in the future outlook for REDD? You can find out in our latest intrinsic value infographic research report.

Is Redde Northgate Making Efficient Use Of Its Profits?

With a high three-year median payout ratio of 56% (implying that the company keeps only 44% of its income) of its business to reinvest into its business), most of Redde Northgate's profits are being paid to shareholders, which explains the absence of growth in earnings.

Additionally, Redde Northgate has paid dividends over a period of at least ten years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 46%. As a result, Redde Northgate's ROE is not expected to change by much either, which we inferred from the analyst estimate of 12% for future ROE.

Conclusion

On the whole, we feel that the performance shown by Redde Northgate can be open to many interpretations. On the one hand, the company does have a decent rate of return, however, its earnings growth number is quite disappointing and as discussed earlier, the low retained earnings is hampering the growth. In addition, on studying the latest analyst forecasts, we found that the company's earnings are expected to continue to shrink. 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.