With its stock down 11% over the past month, it is easy to disregard Xiamen Leading Optics (SHSE:605118). However, the company's fundamentals look pretty decent, and long-term financials are usually aligned with future market price movements. Specifically, we decided to study Xiamen Leading Optics' ROE in this article.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors' money. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

How Is ROE Calculated?

The formula for ROE is:

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

So, based on the above formula, the ROE for Xiamen Leading Optics is:

11% = CN¥159m ÷ CN¥1.5b (Based on the trailing twelve months to March 2024).

The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each CN¥1 of shareholders' capital it has, the company made CN¥0.11 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 Xiamen Leading Optics' Earnings Growth And 11% ROE

When you first look at it, Xiamen Leading Optics' ROE doesn't look that attractive. However, the fact that the its ROE is quite higher to the industry average of 6.3% doesn't go unnoticed by us. But seeing Xiamen Leading Optics' five year net income decline of 3.7% over the past five years, we might rethink that. Remember, the company's ROE is a bit low to begin with, just that it is higher than the industry average. Hence, this goes some way in explaining the shrinking earnings.

That being said, we compared Xiamen Leading Optics' 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 6.4% in the same 5-year 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). Doing so will help them establish if the stock's future looks promising or ominous. Is Xiamen Leading Optics fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Xiamen Leading Optics Making Efficient Use Of Its Profits?

In spite of a normal three-year median payout ratio of 35% (that is, a retention ratio of 65%), the fact that Xiamen Leading Optics' earnings have shrunk is quite puzzling. It looks like there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.

Additionally, Xiamen Leading Optics has paid dividends over a period of three years, which means that the company's management is rather focused on keeping up its dividend payments, regardless of the shrinking earnings.

Summary

Overall, we feel that Xiamen Leading Optics certainly does have some positive factors to consider. Although, we are disappointed to see a lack of growth in earnings even in spite of a moderate ROE and and a high reinvestment rate. We believe that there might be some outside factors that could be having a negative impact on the business. While we won't completely dismiss the company, what we would do, is try to ascertain how risky the business is to make a more informed decision around the company. You can see the 3 risks we have identified for Xiamen Leading Optics by visiting our risks dashboard for free on our platform here.

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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.