Kingsoft (HKG:3888) has had a great run on the share market with its stock up by a significant 61% over the last three months. However, we wonder if the company's inconsistent financials would have any adverse impact on the current share price momentum. Specifically, we decided to study Kingsoft's ROE in this article.

ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

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 Kingsoft is:

8.6% = CN¥2.4b ÷ CN¥28b (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 HK$1 of shareholders' capital it has, the company made HK$0.09 in profit.

What Has ROE Got To Do With 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.

Kingsoft's Earnings Growth And 8.6% ROE

At first glance, Kingsoft's ROE doesn't look very promising. Yet, a closer study shows that the company's ROE is similar to the industry average of 8.5%. But then again, Kingsoft's five year net income shrunk at a rate of 25%. Bear in mind, the company does have a slightly low ROE. Hence, this goes some way in explaining the shrinking earnings.

So, as a next step, we compared Kingsoft's performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 8.8% over the last few years.

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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. 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 Kingsoft is trading on a high P/E or a low P/E, relative to its industry.

Is Kingsoft Efficiently Re-investing Its Profits?

In spite of a normal three-year median payout ratio of 30% (that is, a retention ratio of 70%), the fact that Kingsoft'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.

Moreover, Kingsoft has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over earnings growth. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 21% over the next three years. Despite the lower expected payout ratio, the company's ROE is not expected to change by much.

Conclusion

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

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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.