Does Redcape Hotel Group’s (ASX:RDC) Weak Fundamentals Mean That The Stock Could Move In The Opposite Direction?

Redcape Hotel Group’s (ASX:RDC) stock up by 1.1{d54a1665abf9e9c0a672e4d38f9dfbddcef0b06673b320158dd31c640423e2e5} over the past week. However, its weak financial performance indicators makes us a bit doubtful if that trend could continue. Specifically, we decided to study Redcape Hotel Group’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 short, ROE shows the profit each dollar generates with respect to its shareholder investments.

Check out our latest analysis for Redcape Hotel Group

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 Redcape Hotel Group is:

1.9{d54a1665abf9e9c0a672e4d38f9dfbddcef0b06673b320158dd31c640423e2e5} = AU$11m ÷ AU$602m (Based on the trailing twelve months to June 2020).

The ‘return’ is the amount earned after tax over the last twelve months. So, this means that for every A$1 of its shareholder’s investments, the company generates a profit of A$0.02.

What Has ROE Got To Do With Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. Based on how much of its profits the company chooses to reinvest or “retain”, we are then able to evaluate a company’s future ability to generate profits. 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.

A Side By Side comparison of Redcape Hotel Group’s Earnings Growth And 1.9{d54a1665abf9e9c0a672e4d38f9dfbddcef0b06673b320158dd31c640423e2e5} ROE

As you can see, Redcape Hotel Group’s ROE looks pretty weak. Not just that, even compared to the industry average of 8.1{d54a1665abf9e9c0a672e4d38f9dfbddcef0b06673b320158dd31c640423e2e5}, the company’s ROE is entirely unremarkable. For this reason, Redcape Hotel Group’s five year net income decline of 60{d54a1665abf9e9c0a672e4d38f9dfbddcef0b06673b320158dd31c640423e2e5} is not surprising given its lower ROE. We reckon that there could also be other factors at play here. Such as – low earnings retention or poor allocation of capital.

Story continues

So, as a next step, we compared Redcape Hotel Group’s performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 4.7{d54a1665abf9e9c0a672e4d38f9dfbddcef0b06673b320158dd31c640423e2e5} in the same period.

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. 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 Redcape Hotel Group is trading on a high P/E or a low P/E, relative to its industry.

Is Redcape Hotel Group Efficiently Re-investing Its Profits?

Redcape Hotel Group has a high three-year median payout ratio of 72{d54a1665abf9e9c0a672e4d38f9dfbddcef0b06673b320158dd31c640423e2e5} (that is, it is retaining 28{d54a1665abf9e9c0a672e4d38f9dfbddcef0b06673b320158dd31c640423e2e5} of its profits). This suggests that the company is paying most of its profits as dividends to its shareholders. This goes some way in explaining why its earnings have been shrinking. 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. To know the 3 risks we have identified for Redcape Hotel Group visit our risks dashboard for free.

Only recently, Redcape Hotel Group stated paying a dividend. This likely means that the management might have concluded that its shareholders have a strong preference for dividends. Looking at the current analyst consensus data, we can see that the company’s future payout ratio is expected to rise to 104{d54a1665abf9e9c0a672e4d38f9dfbddcef0b06673b320158dd31c640423e2e5} over the next three years. Still, forecasts suggest that Redcape Hotel Group’s future ROE will rise to 7.9{d54a1665abf9e9c0a672e4d38f9dfbddcef0b06673b320158dd31c640423e2e5} even though the the company’s payout ratio is expected to rise. We presume that there could some other characteristics of the business that could be driving the anticipated growth in the company’s ROE.

Summary

On the whole, Redcape Hotel Group’s performance is quite a big let-down. Because the company is not reinvesting much into the business, and given the low ROE, it’s not surprising to see the lack or absence of growth in its earnings. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. 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.

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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