Guangzhou Holike Creative HomeLtd (SHSE:603898) has had a great run on the share market with its stock up by a significant 44% over the last three months. However, we decided to pay attention to the company's fundamentals which don't appear to give a clear sign about the company's financial health. Particularly, we will be paying attention to Guangzhou Holike Creative HomeLtd's ROE today.

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

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 Guangzhou Holike Creative HomeLtd is:

4.1% = CN¥130m ÷ CN¥3.1b (Based on the trailing twelve months to September 2024).

The 'return' is the profit over the last twelve months. One way to conceptualize this is that for each CN¥1 of shareholders' capital it has, the company made CN¥0.04 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 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.

Guangzhou Holike Creative HomeLtd's Earnings Growth And 4.1% ROE

It is hard to argue that Guangzhou Holike Creative HomeLtd's ROE is much good in and of itself. Not just that, even compared to the industry average of 9.3%, the company's ROE is entirely unremarkable. Given the circumstances, the significant decline in net income by 8.9% seen by Guangzhou Holike Creative HomeLtd over the last five years is not surprising. We reckon that there could also be other factors at play here. Such as - low earnings retention or poor allocation of capital.

However, when we compared Guangzhou Holike Creative HomeLtd's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 8.1% in the same period. This is quite worrisome.

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. 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 Guangzhou Holike Creative HomeLtd's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Guangzhou Holike Creative HomeLtd Using Its Retained Earnings Effectively?

In spite of a normal three-year median payout ratio of 37% (that is, a retention ratio of 63%), the fact that Guangzhou Holike Creative HomeLtd's 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.

In addition, Guangzhou Holike Creative HomeLtd 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. Based on the latest analysts' estimates, we found that the company's future payout ratio over the next three years is expected to hold steady at 33%. However, Guangzhou Holike Creative HomeLtd's ROE is predicted to rise to 5.5% despite there being no anticipated change in its payout ratio.

Summary

Overall, we have mixed feelings about Guangzhou Holike Creative HomeLtd. 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. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.