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Prada S.p.A.'s (HKG:1913) Stock's Been Going Strong: Could Weak Financials Mean The Market Will Coorect Its Share Price?

Most readers would already be aware that Prada's (HKG:1913) stock increased significantly by 19% over the past month. We, however wanted to have a closer look at its key financial indicators as the markets usually pay for long-term fundamentals, and in this case, they don't look very promising. 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. Put another way, it reveals the company's success at turning shareholder investments into profits.

View our latest analysis for Prada

How To Calculate Return On Equity?

Return on equity can be calculated by using the formula:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

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So, based on the above formula, the ROE for Prada is:

8.6% = €258m ÷ €3.0b (Based on the trailing twelve months to December 2019).

The 'return' is the amount earned after tax over the last twelve months. That means that for every HK$1 worth of shareholders' equity, the company generated HK$0.09 in profit.

What Has ROE Got To Do With Earnings Growth?

Thus far, we have learnt 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. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don’t share these attributes.

Prada's Earnings Growth And 8.6% ROE

When you first look at it, Prada's ROE doesn't look that attractive. However, given that the company's ROE is similar to the average industry ROE of 8.8%, we may spare it some thought. But Prada saw a five year net income decline of 12% over the past five years. Remember, the company's ROE is a bit low to begin with. Hence, this goes some way in explaining the shrinking earnings.

However, when we compared Prada's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 3.8% in the same period. This is quite worrisome.

SEHK:1913 Past Earnings Growth April 20th 2020
SEHK:1913 Past Earnings Growth April 20th 2020

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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. 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 70% (or a retention ratio of 30%). 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.

Additionally, Prada has paid dividends over a period of eight years, which means that the company's management is rather focused on keeping up its dividend payments, regardless of the shrinking earnings. Based on the latest analysts' estimates, we found that the company's future payout ratio over the next three years is expected to hold steady at 64%. As a result, Prada's ROE is not expected to change by much either, which we inferred from the analyst estimate of 7.6% for future ROE.

Conclusion

On the whole, Prada's performance is quite a big let-down. The company has seen a lack of earnings growth as a result of retaining very little profits and whatever little it does retain, is being reinvested at a very low rate of return. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.