Rama Steel Tubes Limited's (NSE:RAMASTEEL) Stock Is Rallying But Financials Look Ambiguous: Will The Momentum Continue?

Most readers would already be aware that Rama Steel Tubes' (NSE:RAMASTEEL) stock increased significantly by 27% over the past three months. 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. In this article, we decided to focus on Rama Steel Tubes' ROE.

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. Put another way, it reveals the company's success at turning shareholder investments into profits.

Check out our latest analysis for Rama Steel Tubes

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 Rama Steel Tubes is:

2.6% = ₹24m ÷ ₹902m (Based on the trailing twelve months to September 2020).

The 'return' refers to a company's earnings over the last year. Another way to think of that is that for every ₹1 worth of equity, the company was able to earn ₹0.03 in profit.

Why Is ROE Important For Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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.

Rama Steel Tubes' Earnings Growth And 2.6% ROE

It is hard to argue that Rama Steel Tubes' ROE is much good in and of itself. Even when compared to the industry average of 7.6%, the ROE figure is pretty disappointing. Given the circumstances, the significant decline in net income by 16% seen by Rama Steel Tubes over the last five years is not surprising. We reckon that there could also be other factors at play here. Such as - low earnings retention or poor allocation of capital.

That being said, we compared Rama Steel Tubes' 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 13% in the same period.

Earnings growth is a huge factor in stock valuation. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. Doing so will help them establish if the stock's future looks promising or ominous. 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 Rama Steel Tubes is trading on a high P/E or a low P/E, relative to its industry.

Is Rama Steel Tubes Efficiently Re-investing Its Profits?

Summary

On the whole, we feel that the performance shown by Rama Steel Tubes can be open to many interpretations. Even though it appears to be retaining most of its profits, given the low ROE, investors may not be benefitting from all that reinvestment after all. The low earnings growth suggests our theory correct. Wrapping up, we would proceed with caution with this company and one way of doing that would be to look at the risk profile of the business. Our risks dashboard would have the 3 risks we have identified for Rama Steel Tubes.

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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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