With its stock down 5.9% over the past month, it is easy to disregard Prada (HKG:1913). 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 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?

ROE 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 Prada is:

12% = €388m ÷ €3.2b (Based on the trailing twelve months to June 2022).

The 'return' is the profit over the last twelve months. Another way to think of that is that for every HK$1 worth of equity, the company was able to earn HK$0.12 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. 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 Prada's Earnings Growth And 12% ROE

To start with, Prada's ROE looks acceptable. Further, the company's ROE is similar to the industry average of 11%. Despite the moderate return on equity, Prada has posted a net income growth of 2.3% over the past five years. A few likely reasons that could be keeping earnings growth low are - the company has a high payout ratio or the business has allocated capital poorly, for instance.

Next, on comparing with the industry net income growth, we found that Prada's growth is quite high when compared to the industry average growth of 0.6% in the same period, which is great to see.

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). 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 Making Efficient Use Of Its Profits?

The high three-year median payout ratio of 53% (that is, the company retains only 47% of its income) over the past three years for Prada suggests that the company's earnings growth was lower as a result of paying out a majority of its earnings.

In addition, Prada has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Looking at the current analyst consensus data, we can see that the company's future payout ratio is expected to rise to 64% over the next three years. Regardless, the future ROE for Prada is speculated to rise to 16% despite the anticipated increase in the payout ratio. There could probably be other factors that could be driving the future growth in the ROE.

Summary

Overall, we are quite pleased with Prada's performance. In particular, its high ROE is quite noteworthy and also the probable explanation behind its considerable earnings growth. Yet, the company is retaining a small portion of its profits. Which means that the company has been able to grow its earnings in spite of it, so that's not too bad. With that said, the latest industry analyst forecasts reveal that the company's earnings are expected to accelerate. 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.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.