Shanghai Huafon Aluminium (SHSE:601702) has had a rough three months with its share price down 23%. But if you pay close attention, you might gather that its strong financials could mean that the stock could potentially see an increase in value in the long-term, given how markets usually reward companies with good financial health. Specifically, we decided to study Shanghai Huafon Aluminium's ROE in this article.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors' money. 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?

The formula for ROE is:

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

So, based on the above formula, the ROE for Shanghai Huafon Aluminium is:

21% = CN¥1.0b ÷ CN¥4.9b (Based on the trailing twelve months to June 2024).

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¥0.21 in profit.

Why Is ROE Important For 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. 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.

Shanghai Huafon Aluminium's Earnings Growth And 21% ROE

To start with, Shanghai Huafon Aluminium's ROE looks acceptable. On comparing with the average industry ROE of 7.4% the company's ROE looks pretty remarkable. Probably as a result of this, Shanghai Huafon Aluminium was able to see an impressive net income growth of 36% over the last five years. We reckon that there could also be other factors at play here. Such as - high earnings retention or an efficient management in place.

Next, on comparing with the industry net income growth, we found that Shanghai Huafon Aluminium's growth is quite high when compared to the industry average growth of 11% in the same period, which is great to see.

Earnings growth is a huge factor in stock valuation. 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. 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 Huafon Aluminium is trading on a high P/E or a low P/E, relative to its industry.

Is Shanghai Huafon Aluminium Using Its Retained Earnings Effectively?

Shanghai Huafon Aluminium's three-year median payout ratio to shareholders is 13%, which is quite low. This implies that the company is retaining 87% of its profits. So it looks like Shanghai Huafon Aluminium is reinvesting profits heavily to grow its business, which shows in its earnings growth.

Additionally, Shanghai Huafon Aluminium has paid dividends over a period of three years which means that the company is pretty serious about sharing its profits with shareholders. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to rise to 20% over the next three years. Regardless, the ROE is not expected to change much for the company despite the higher expected payout ratio.

Summary

In total, we are pretty happy with Shanghai Huafon Aluminium's performance. In particular, it's great to see that the company is investing heavily into its business and along with a high rate of return, that has resulted in a sizeable growth in its earnings. Having said that, the company's earnings growth is expected to slow down, as forecasted in the current analyst estimates. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com