It is hard to get excited after looking at Huadong Medicine's (SZSE:000963) recent performance, when its stock has declined 4.9% over the past three months. However, stock prices are usually driven by a company's financials over the long term, which in this case look pretty respectable. In this article, we decided to focus on Huadong Medicine's ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors' money. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

How Do You 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 Huadong Medicine is:

14% = CN¥3.1b ÷ CN¥22b (Based on the trailing twelve months to June 2024).

The 'return' is the yearly profit. One way to conceptualize this is that for each CN¥1 of shareholders' capital it has, the company made CN¥0.14 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.

Huadong Medicine's Earnings Growth And 14% ROE

To begin with, Huadong Medicine seems to have a respectable ROE. Further, the company's ROE compares quite favorably to the industry average of 6.4%. However, we are curious as to how the high returns still resulted in flat growth for Huadong Medicine in the past five years. Based on this, we feel that there might be other reasons which haven't been discussed so far in this article that could be hampering the company's growth. Such as, the company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.

As a next step, we compared Huadong Medicine's net income growth with the industry and discovered that the industry saw an average growth of 5.1% in the same period.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. This then helps them determine if the stock is placed for a bright or bleak future. If you're wondering about Huadong Medicine's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Huadong Medicine Using Its Retained Earnings Effectively?

Huadong Medicine has a low three-year median payout ratio of 21% (or a retention ratio of 79%) but the negligible earnings growth number doesn't reflect this as high growth usually follows high profit retention.

Additionally, Huadong Medicine has paid dividends over a period of at least ten years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth. Looking at the current analyst consensus data, we can see that the company's future payout ratio is expected to rise to 33% over the next three years. However, the company's ROE is not expected to change by much despite the higher expected payout ratio.

Conclusion

In total, it does look like Huadong Medicine has some positive aspects to its business. However, given the high ROE and high profit retention, we would expect the company to be delivering strong earnings growth, but that isn't the case here. This suggests that there might be some external threat to the business, that's hampering its growth. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page 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.