It is hard to get excited after looking at Hong Kong and China Gas' (HKG:3) recent performance, when its stock has declined 6.7% over the past three months. Given that stock prices are usually driven by a company's fundamentals over the long term, which in this case look pretty weak, we decided to study the company's key financial indicators. Specifically, we decided to study Hong Kong and China Gas' 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. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

How To Calculate Return On Equity?

Return on equity 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 Hong Kong and China Gas is:

9.4% = HK$6.4b ÷ HK$68b (Based on the trailing twelve months to June 2024).

The 'return' refers to a company's earnings over the last year. So, this means that for every HK$1 of its shareholder's investments, the company generates a profit of HK$0.09.

What Is The Relationship Between ROE And Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don't share these attributes.

A Side By Side comparison of Hong Kong and China Gas' Earnings Growth And 9.4% ROE

At first glance, Hong Kong and China Gas' ROE doesn't look very promising. However, given that the company's ROE is similar to the average industry ROE of 8.4%, we may spare it some thought. Having said that, Hong Kong and China Gas' five year net income decline rate was 6.8%. Remember, the company's ROE is a bit low to begin with. Hence, this goes some way in explaining the shrinking earnings.

Next, when we compared with the industry, which has shrunk its earnings at a rate of 1.1% in the same 5-year period, we still found Hong Kong and China Gas' performance to be quite bleak, because the company has been shrinking its earnings faster than the industry.

Earnings growth is an important metric to consider when valuing a stock. 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 Hong Kong and China Gas is trading on a high P/E or a low P/E, relative to its industry.

Is Hong Kong and China Gas Using Its Retained Earnings Effectively?

With a three-year median payout ratio as high as 119%,Hong Kong and China Gas' shrinking earnings don't come as a surprise as the company is paying a dividend which is beyond its means. Its usually very hard to sustain dividend payments that are higher than reported profits. You can see the 2 risks we have identified for Hong Kong and China Gas by visiting our risks dashboard for free on our platform here.

In addition, Hong Kong and China Gas 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. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 89% over the next three years. As a result, the expected drop in Hong Kong and China Gas' payout ratio explains the anticipated rise in the company's future ROE to 12%, over the same period.

Summary

In total, we would have a hard think before deciding on any investment action concerning Hong Kong and China Gas. Particularly, its ROE is a huge disappointment, not to mention its lack of proper reinvestment into the business. As a result its earnings growth has also been quite disappointing. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts 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.