Shanghai Mechanical & Electrical IndustryLtd (SHSE:600835) has had a great run on the share market with its stock up by a significant 18% over the last three months. But the company's key financial indicators appear to be differing across the board and that makes us question whether or not the company's current share price momentum can be maintained. In this article, we decided to focus on Shanghai Mechanical & Electrical IndustryLtd's ROE.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

Check out our latest analysis for Shanghai Mechanical & Electrical IndustryLtd

How Is ROE Calculated?

The formula for return on equity is:

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

So, based on the above formula, the ROE for Shanghai Mechanical & Electrical IndustryLtd is:

7.1% = CN¥1.1b ÷ CN¥15b (Based on the trailing twelve months to March 2022).

The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each CN¥1 of shareholders' capital it has, the company made CN¥0.07 in profit.

Why Is ROE Important For 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. Assuming everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.

Shanghai Mechanical & Electrical IndustryLtd's Earnings Growth And 7.1% ROE

On the face of it, Shanghai Mechanical & Electrical IndustryLtd's ROE is not much to talk about. Yet, a closer study shows that the company's ROE is similar to the industry average of 8.2%. But then again, Shanghai Mechanical & Electrical IndustryLtd's five year net income shrunk at a rate of 8.5%. Remember, the company's ROE is a bit low to begin with. So that's what might be causing earnings growth to shrink.

That being said, we compared Shanghai Mechanical & Electrical IndustryLtd's performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 14% in the same period.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. Doing so will help them establish if the stock's future looks promising or ominous. Is Shanghai Mechanical & Electrical IndustryLtd fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Shanghai Mechanical & Electrical IndustryLtd Using Its Retained Earnings Effectively?

Despite having a normal three-year median payout ratio of 35% (where it is retaining 65% of its profits), Shanghai Mechanical & Electrical IndustryLtd has seen a decline in earnings as we saw above. It looks like there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.

In addition, Shanghai Mechanical & Electrical IndustryLtd 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. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 35% of its profits over the next three years. Regardless, the future ROE for Shanghai Mechanical & Electrical IndustryLtd is predicted to rise to 9.2% despite there being not much change expected in its payout ratio.

Conclusion

Overall, we have mixed feelings about Shanghai Mechanical & Electrical IndustryLtd. While the company does have a high rate of reinvestment, the low ROE means that all that reinvestment is not reaping any benefit to its investors, and moreover, its having a negative impact on the earnings growth. That being so, the latest industry analyst forecasts show that the analysts are expecting to see a huge improvement in the company's earnings growth rate. 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.

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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.