With its stock down 20% over the past month, it is easy to disregard Shandong Shengli (SZSE:000407). We, however decided to study the company's financials to determine if they have got anything to do with the price decline. Long-term fundamentals are usually what drive market outcomes, so it's worth paying close attention. Specifically, we decided to study Shandong Shengli'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. Put another way, it reveals the company's success at turning shareholder investments into profits.

How Is ROE Calculated?

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 Shandong Shengli is:

4.5% = CN¥144m ÷ CN¥3.2b (Based on the trailing twelve months to September 2023).

The 'return' is the yearly profit. That means that for every CN¥1 worth of shareholders' equity, the company generated CN¥0.05 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. 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. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don't share these attributes.

Shandong Shengli's Earnings Growth And 4.5% ROE

It is quite clear that Shandong Shengli's ROE is rather low. Even when compared to the industry average of 9.3%, the ROE figure is pretty disappointing. For this reason, Shandong Shengli's five year net income decline of 6.6% is not surprising given its lower ROE. We reckon that there could also be other factors at play here. Such as - low earnings retention or poor allocation of capital.

That being said, we compared Shandong Shengli'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 5.6% 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. 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 Shandong Shengli's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Shandong Shengli Using Its Retained Earnings Effectively?

Shandong Shengli's low three-year median payout ratio of 12% (or a retention ratio of 88%) over the last three years should mean that the company is retaining most of its earnings to fuel its growth but the company's earnings have actually shrunk. This typically shouldn't be the case when a company is retaining most of its earnings. So there could be some other explanations in that regard. For example, the company's business may be deteriorating.

In addition, Shandong Shengli has been paying dividends over a period of eight years suggesting that keeping up dividend payments is preferred by the management even though earnings have been in decline.

Conclusion

In total, we're a bit ambivalent about Shandong Shengli's performance. While the company does have a high rate of profit retention, its low rate of return is probably hampering its 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. Our risks dashboard will have the 1 risk we have identified for Shandong Shengli.

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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.