Most readers would already be aware that Shanghai Karon Eco-Valve Manufacturing's (SZSE:301151) stock increased significantly by 20% over the past week. But the company's key financial indicators appear to be differing across the board and that makes us question whether or not the company's current share price momentum can be maintained. Particularly, we will be paying attention to Shanghai Karon Eco-Valve Manufacturing'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 other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

How To Calculate Return On Equity?

ROE 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 Karon Eco-Valve Manufacturing is:

4.0% = CN¥81m ÷ CN¥2.0b (Based on the trailing twelve months to September 2023).

The 'return' is the amount earned after tax over the last twelve months. Another way to think of that is that for every CN¥1 worth of equity, the company was able to earn CN¥0.04 in profit.

What Is The Relationship Between ROE And 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 Karon Eco-Valve Manufacturing's Earnings Growth And 4.0% ROE

It is hard to argue that Shanghai Karon Eco-Valve Manufacturing's ROE is much good in and of itself. Even when compared to the industry average of 7.4%, the ROE figure is pretty disappointing. Therefore, it might not be wrong to say that the five year net income decline of 5.5% seen by Shanghai Karon Eco-Valve Manufacturing was possibly a result of it having a lower ROE. We believe that there also might be other aspects that are negatively influencing the company's earnings prospects. For instance, the company has a very high payout ratio, or is faced with competitive pressures.

So, as a next step, we compared Shanghai Karon Eco-Valve Manufacturing'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 11% over the last few years.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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. 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 Shanghai Karon Eco-Valve Manufacturing is trading on a high P/E or a low P/E, relative to its industry.

Is Shanghai Karon Eco-Valve Manufacturing Making Efficient Use Of Its Profits?

Despite having a normal three-year median payout ratio of 35% (where it is retaining 65% of its profits), Shanghai Karon Eco-Valve Manufacturing has seen a decline in earnings as we saw above. It looks like there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.

Only recently, Shanghai Karon Eco-Valve Manufacturing stated paying a dividend. This likely means that the management might have concluded that its shareholders have a strong preference for dividends.

Conclusion

On the whole, we feel that the performance shown by Shanghai Karon Eco-Valve Manufacturing 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. 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 Shanghai Karon Eco-Valve Manufacturing 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.