Shanghai Mechanical & Electrical IndustryLtd (SHSE:600835) has had a great run on the share market with its stock up by a significant 16% 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 Shanghai Mechanical & Electrical IndustryLtd's ROE in this article.

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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.

Check out our latest analysis for Shanghai Mechanical & Electrical IndustryLtd

How Do You 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 Shanghai Mechanical & Electrical IndustryLtd is:

6.0% = CN¥928m ÷ CN¥15b (Based on the trailing twelve months to September 2022).

The 'return' is the income the business earned over the last year. That means that for every CN¥1 worth of shareholders' equity, the company generated CN¥0.06 in profit.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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 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.

Shanghai Mechanical & Electrical IndustryLtd's Earnings Growth And 6.0% ROE

At first glance, Shanghai Mechanical & Electrical IndustryLtd's ROE doesn't look very promising. Next, when compared to the average industry ROE of 7.9%, the company's ROE leaves us feeling even less enthusiastic. Given the circumstances, the significant decline in net income by 12% seen by Shanghai Mechanical & Electrical IndustryLtd over the last five years is not surprising. However, there could also be other factors causing the earnings to decline. For example, it is possible that the business has allocated capital poorly or that the company has a very high payout ratio.

However, when we compared Shanghai Mechanical & Electrical IndustryLtd's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 11% in the same period. This is quite worrisome.

Earnings growth is an important metric to consider when valuing a stock. 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. If you're wondering about Shanghai Mechanical & Electrical IndustryLtd's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Shanghai Mechanical & Electrical IndustryLtd Efficiently Re-investing Its Profits?

Looking at its three-year median payout ratio of 35% (or a retention ratio of 65%) which is pretty normal, Shanghai Mechanical & Electrical IndustryLtd's declining earnings is rather baffling as one would expect to see a fair bit of growth when a company is retaining a good portion of its profits. 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, Shanghai Mechanical & Electrical IndustryLtd 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 35%. However, Shanghai Mechanical & Electrical IndustryLtd's ROE is predicted to rise to 8.0% despite there being no anticipated change in its payout ratio.

Conclusion

In total, we're a bit ambivalent about Shanghai Mechanical & Electrical IndustryLtd's performance. 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. Wrapping up, we would proceed with caution with this company and one way of doing that would be to look at the risk profile of the business. You can see the 4 risks we have identified for Shanghai Mechanical & Electrical IndustryLtd 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.