Shanghai Pharmaceuticals Holding's (SHSE:601607) stock is up by a considerable 13% over the past three months. However, we wonder if the company's inconsistent financials would have any adverse impact on the current share price momentum. In this article, we decided to focus on Shanghai Pharmaceuticals Holding's ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors' money. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

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 Pharmaceuticals Holding is:

6.3% = CN¥5.2b ÷ CN¥83b (Based on the trailing twelve months to September 2024).

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¥0.06 in profit.

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. Depending on how much of these profits the company reinvests or "retains", and how effectively it does so, we are then able to assess a company's earnings growth potential. 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 Pharmaceuticals Holding's Earnings Growth And 6.3% ROE

On the face of it, Shanghai Pharmaceuticals Holding'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 6.7%. Having said that, Shanghai Pharmaceuticals Holding's net income growth over the past five years is more or less flat. Bear in mind, the company's ROE is not very high. Hence, this provides some context to the flat earnings growth seen by the company.

Next, on comparing with the industry net income growth, we found that Shanghai Pharmaceuticals Holding's reported growth was a little less than the industry growth of2.0% over the last few years.

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 Shanghai Pharmaceuticals Holding is trading on a high P/E or a low P/E, relative to its industry.

Is Shanghai Pharmaceuticals Holding Using Its Retained Earnings Effectively?

Despite having a normal three-year median payout ratio of 38% (implying that the company keeps 62% of its income) over the last three years, Shanghai Pharmaceuticals Holding has seen a negligible amount of growth in earnings as we saw above. So there could be some other explanation in that regard. For instance, the company's business may be deteriorating.

Additionally, Shanghai Pharmaceuticals Holding has paid dividends over a period of at least ten years, which means that the company's management is determined to pay dividends even if it means little to no earnings 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 38%. Still, forecasts suggest that Shanghai Pharmaceuticals Holding's future ROE will rise to 8.0% even though the the company's payout ratio is not expected to change by much.

Summary

On the whole, we feel that the performance shown by Shanghai Pharmaceuticals Holding can be open to many interpretations. 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. 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.

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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.