With its stock down 4.4% over the past three months, it is easy to disregard Prada (HKG:1913). To decide if this trend could continue, we decided to look at its weak fundamentals as they shape the long-term market trends. In this article, we decided to focus on Prada's ROE.
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 other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
How To 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 Prada is:
7.8% = €226m ÷ €2.9b (Based on the trailing twelve months to June 2021).
The 'return' is the profit over the last twelve months. One way to conceptualize this is that for each HK$1 of shareholders' capital it has, the company made HK$0.08 in profit.
What Has ROE Got To Do With 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.
Prada's Earnings Growth And 7.8% ROE
At first glance, Prada's ROE doesn't look very promising. Yet, a closer study shows that the company's ROE is similar to the industry average of 8.0%. Having said that, Prada's five year net income decline rate was 27%. Bear in mind, the company does have a slightly low ROE. Hence, this goes some way in explaining the shrinking earnings.
Furthermore, even when compared to the industry, which has been shrinking its earnings at a rate 5.3% in the same period, we found that Prada's performance is pretty disappointing, as it suggests that the company has been shrunk its earnings at a rate faster than the industry.
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). Doing so will help them establish if the stock's future looks promising or ominous. If you're wondering about Prada's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.
Is Prada Efficiently Re-investing Its Profits?
Prada'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 60% (or a retention ratio of 40%). 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.
In addition, Prada has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 64%. Still, forecasts suggest that Prada's future ROE will rise to 15% even though the the company's payout ratio is not expected to change by much.
On the whole, Prada's performance is quite a big let-down. As a result of its low ROE and lack of much reinvestment into the business, the company has seen a disappointing earnings growth rate. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. 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. 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.