With its stock down 23% over the past three months, it is easy to disregard Zhe Jiang Headman MachineryLtd (SHSE:688577). It seems that the market might have completely ignored the positive aspects of the company's fundamentals and decided to weigh-in more on the negative aspects. Fundamentals usually dictate market outcomes so it makes sense to study the company's financials. Particularly, we will be paying attention to Zhe Jiang Headman MachineryLtd's ROE today.

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 short, ROE shows the profit each dollar generates with respect to its shareholder investments.

How Do You Calculate Return On Equity?

The formula for ROE is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Zhe Jiang Headman MachineryLtd is:

3.4% = CN¥30m ÷ CN¥871m (Based on the trailing twelve months to December 2023).

The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each CN¥1 of shareholders' capital it has, the company made CN¥0.03 in profit.

Why Is ROE Important For 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. 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.

A Side By Side comparison of Zhe Jiang Headman MachineryLtd's Earnings Growth And 3.4% ROE

It is quite clear that Zhe Jiang Headman MachineryLtd's ROE is rather low. Even compared to the average industry ROE of 7.5%, the company's ROE is quite dismal. Therefore, it might not be wrong to say that the five year net income decline of 2.4% seen by Zhe Jiang Headman MachineryLtd was possibly a result of it having a lower ROE. We reckon that there could also be other factors at play here. For example, the business has allocated capital poorly, or that the company has a very high payout ratio.

That being said, we compared Zhe Jiang Headman MachineryLtd'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.

Earnings growth is a huge factor in stock valuation. It's important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is Zhe Jiang Headman MachineryLtd fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Zhe Jiang Headman MachineryLtd Efficiently Re-investing Its Profits?

Looking at its three-year median payout ratio of 32% (or a retention ratio of 68%) which is pretty normal, Zhe Jiang Headman MachineryLtd'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. So there could be some other explanations in that regard. For instance, the company's business may be deteriorating.

Additionally, Zhe Jiang Headman MachineryLtd has paid dividends over a period of three years, which means that the company's management is rather focused on keeping up its dividend payments, regardless of the shrinking earnings.

Summary

Overall, we have mixed feelings about Zhe Jiang Headman MachineryLtd. 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. To know the 3 risks we have identified for Zhe Jiang Headman MachineryLtd visit our risks dashboard for free.

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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.