Most readers would already be aware that Shanghai New World's (SHSE:600628) stock increased significantly by 49% over the past three months. However, we wonder if the company's inconsistent financials would have any adverse impact on the current share price momentum. Particularly, we will be paying attention to Shanghai New World's ROE today.

ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

How Do You 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 New World is:

1.1% = CN¥45m ÷ CN¥4.2b (Based on the trailing twelve months to September 2024).

The 'return' is the profit over the last twelve months. One way to conceptualize this is that for each CN¥1 of shareholders' capital it has, the company made CN¥0.01 in profit.

What Is The Relationship Between ROE And Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. 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.

Shanghai New World's Earnings Growth And 1.1% ROE

It is quite clear that Shanghai New World's ROE is rather low. Even when compared to the industry average of 7.7%, the ROE figure is pretty disappointing. Given the circumstances, the significant decline in net income by 7.7% seen by Shanghai New World over the last five years is not surprising. However, there could also be other factors causing the earnings to decline. Such as - low earnings retention or poor allocation of capital.

However, when we compared Shanghai New World's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 9.1% in the same period. This is quite worrisome.

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). 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 New World is trading on a high P/E or a low P/E, relative to its industry.

Is Shanghai New World Using Its Retained Earnings Effectively?

In spite of a normal three-year median payout ratio of 48% (that is, a retention ratio of 52%), the fact that Shanghai New World's earnings have shrunk is quite puzzling. It looks like there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.

Moreover, Shanghai New World has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over earnings growth.

Summary

Overall, we have mixed feelings about Shanghai New World. 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. You can see the 2 risks we have identified for Shanghai New World by visiting our risks dashboard for free on our platform here.

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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.