Warpaint London PLC's (LON:W7L) Stock's Been Going Strong: Could Weak Financials Mean The Market Will Coorect Its Share Price?

Warpaint London's (LON:W7L) stock is up by a considerable 63% over the past three months. However, we decided to pay close attention to its weak financials as we are doubtful that the current momentum will keep up, given the scenario. Specifically, we decided to study Warpaint London's ROE in this article.

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.

Check out our latest analysis for Warpaint London

How Is ROE Calculated?

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:

3.4% = UK£1.4m ÷ UK£40m (Based on the trailing twelve months to December 2019).

The 'return' is the amount earned after tax over the last twelve months. One way to conceptualize this is that for each £1 of shareholders' capital it has, the company made £0.03 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. 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. 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.

A Side By Side comparison of Warpaint London's Earnings Growth And 3.4% ROE

When you first look at it, Warpaint London's ROE doesn't look that attractive. Next, when compared to the average industry ROE of 10%, the company's ROE leaves us feeling even less enthusiastic. Therefore, it might not be wrong to say that the five year net income decline of 11% seen by Warpaint London was probably the result of it having a lower ROE. We reckon that there could also be other factors at play here. For instance, the company has a very high payout ratio, or is faced with competitive pressures.

However, when we compared Warpaint London's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 18% in the same period. This is quite worrisome.

Earnings growth is an important metric to consider when valuing a stock. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is W7L fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is Warpaint London Using Its Retained Earnings Effectively?

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 70% (or a retention ratio of 30%). With only very little left to reinvest into the business, growth in earnings is far from likely. You can see the 4 risks we have identified for Warpaint London by visiting our risks dashboard for free on our platform here.

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 62%.

Conclusion

On the whole, Warpaint London'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. 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.

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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