Shanghai Mechanical & Electrical IndustryLtd's (SHSE:600835) stock is up by a considerable 12% over the past three months. We wonder if and what role the company's financials play in that price change as a company's long-term fundamentals usually dictate market outcomes. In this article, we decided to focus on Shanghai Mechanical & Electrical IndustryLtd's ROE.

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.

View our latest analysis for Shanghai Mechanical & Electrical IndustryLtd

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 Shanghai Mechanical & Electrical IndustryLtd is:

10% = CN¥1.6b ÷ CN¥16b (Based on the trailing twelve months to March 2023).

The 'return' is the yearly profit. So, this means that for every CN¥1 of its shareholder's investments, the company generates a profit of CN¥0.10.

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. 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 10% ROE

When you first look at it, Shanghai Mechanical & Electrical IndustryLtd's ROE doesn't look that attractive. However, the fact that the company's ROE is higher than the average industry ROE of 7.4%, is definitely interesting. But then again, seeing that Shanghai Mechanical & Electrical IndustryLtd's net income shrunk at a rate of 11% in the past five years, makes us think again. Remember, the company's ROE is a bit low to begin with, just that it is higher than the industry average. Hence, this goes some way in explaining the shrinking earnings.

That being said, we compared Shanghai Mechanical & Electrical IndustryLtd's performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 11% in the same 5-year period.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. 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 Using Its Retained Earnings Effectively?

Despite having a normal three-year median payout ratio of 37% (where it is retaining 63% of its profits), Shanghai Mechanical & Electrical IndustryLtd has seen a decline in earnings as we saw above. So there could be some other explanations in that regard. For instance, the company's business may be deteriorating.

In addition, Shanghai Mechanical & Electrical IndustryLtd 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.

Summary

On the whole, we do feel that Shanghai Mechanical & Electrical IndustryLtd has some positive attributes. Although, we are disappointed to see a lack of growth in earnings even in spite of a moderate ROE and and a high reinvestment rate. We believe that there might be some outside factors that could be having a negative impact on the business. 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. 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.