It is hard to get excited after looking at Red Metal's (ASX:RDM) recent performance, when its stock has declined 4.3% over the past three months. But if you pay close attention, you might gather that its strong financials could mean that the stock could potentially see an increase in value in the long-term, given how markets usually reward companies with good financial health. In this article, we decided to focus on Red Metal's ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. 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 Red Metal

How Do You Calculate Return On Equity?

The formula for ROE is:

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

So, based on the above formula, the ROE for Red Metal is:

16% = AU$259k ÷ AU$1.6m (Based on the trailing twelve months to June 2020).

The 'return' is the income the business earned over the last year. So, this means that for every A$1 of its shareholder's investments, the company generates a profit of A$0.16.

What Is The Relationship Between ROE And 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.

Red Metal's Earnings Growth And 16% ROE

At first glance, Red Metal seems to have a decent ROE. Further, the company's ROE compares quite favorably to the industry average of 13%. This certainly adds some context to Red Metal's decent 20% net income growth seen over the past five years.

We then compared Red Metal's net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 32% in the same period, which is a bit concerning.

Earnings growth is an important metric to consider when valuing a stock. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). 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 Red Metal's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Red Metal Using Its Retained Earnings Effectively?

Summary

On the whole, we feel that Red Metal's performance has been quite good. In particular, it's great to see that the company is investing heavily into its business and along with a high rate of return, that has resulted in a respectable growth in its earnings. If the company continues to grow its earnings the way it has, that could have a positive impact on its share price given how earnings per share influence long-term share prices. Let's not forget, business risk is also one of the factors that affects the price of the stock. So this is also an important area that investors need to pay attention to before making a decision on any business. To know the 4 risks we have identified for Red Metal visit our risks dashboard for free.

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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