With its stock down 20% over the past three months, it is easy to disregard Hangzhou Alltest Biotech (SHSE:688606). It is possible that the markets have ignored the company's differing financials and decided to lean-in to the negative sentiment. Long-term fundamentals are usually what drive market outcomes, so it's worth paying close attention. Particularly, we will be paying attention to Hangzhou Alltest Biotech's ROE today.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors' money. Put another way, it reveals the company's success at turning shareholder investments into profits.

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 Hangzhou Alltest Biotech is:

4.8% = CN¥180m ÷ CN¥3.8b (Based on the trailing twelve months to December 2023).

The 'return' is the yearly profit. One way to conceptualize this is that for each CN¥1 of shareholders' capital it has, the company made CN¥0.05 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. 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.

Hangzhou Alltest Biotech's Earnings Growth And 4.8% ROE

It is quite clear that Hangzhou Alltest Biotech's ROE is rather low. Even when compared to the industry average of 10.0%, the ROE figure is pretty disappointing. Therefore, the disappointing ROE therefore provides a background to Hangzhou Alltest Biotech's very little net income growth of 4.7% over the past five years.

We then compared Hangzhou Alltest Biotech's net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 15% in the same 5-year period, which is a bit concerning.

Earnings growth is a huge factor in stock valuation. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. 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 Hangzhou Alltest Biotech is trading on a high P/E or a low P/E, relative to its industry.

Is Hangzhou Alltest Biotech Using Its Retained Earnings Effectively?

Hangzhou Alltest Biotech has a low three-year median payout ratio of 13% (meaning, the company keeps the remaining 87% of profits) which means that the company is retaining more of its earnings. This should be reflected in its earnings growth number, but that's not the case. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.

Moreover, Hangzhou Alltest Biotech has been paying dividends for three years, which is a considerable amount of time, suggesting that management must have perceived that the shareholders prefer dividends over earnings growth.

Conclusion

Overall, we have mixed feelings about Hangzhou Alltest Biotech. Even though it appears to be retaining most of its profits, given the low ROE, investors may not be benefitting from all that reinvestment after all. The low earnings growth suggests our theory correct. Wrapping up, we would proceed with caution with this company and one way of doing that would be to look at the risk profile of the business. Our risks dashboard would have the 2 risks we have identified for Hangzhou Alltest Biotech.

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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.