It is hard to get excited after looking at Chengdu Lihang Technology CoLtd's (SHSE:603261) recent performance, when its stock has declined 30% over the past three months. 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. In this article, we decided to focus on Chengdu Lihang Technology CoLtd's ROE.

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 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 Chengdu Lihang Technology CoLtd is:

2.8% = CN¥24m ÷ CN¥876m (Based on the trailing twelve months to September 2023).

The 'return' refers to a company's earnings over the last year. That means that for every CN¥1 worth of shareholders' equity, the company generated CN¥0.03 in profit.

What Has ROE Got To Do With Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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.

A Side By Side comparison of Chengdu Lihang Technology CoLtd's Earnings Growth And 2.8% ROE

It is quite clear that Chengdu Lihang Technology CoLtd's ROE is rather low. Not just that, even compared to the industry average of 5.8%, the company's ROE is entirely unremarkable. Given the circumstances, the significant decline in net income by 18% seen by Chengdu Lihang Technology CoLtd over the last five years is not surprising. 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 Chengdu Lihang Technology CoLtd'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 13% in the same 5-year period.

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). By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is Chengdu Lihang Technology CoLtd fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Chengdu Lihang Technology CoLtd Efficiently Re-investing Its Profits?

Looking at its three-year median payout ratio of 29% (or a retention ratio of 71%) which is pretty normal, Chengdu Lihang Technology CoLtd'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. 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, Chengdu Lihang Technology CoLtd stated paying a dividend. This likely means that the management might have concluded that its shareholders have a strong preference for dividends.

Conclusion

In total, we're a bit ambivalent about Chengdu Lihang Technology CoLtd's performance. While the company does have a high rate of reinvestment, the low ROE means that all that reinvestment is not reaping any benefit to its investors, and moreover, its having a negative impact on the 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. Our risks dashboard would have the 4 risks we have identified for Chengdu Lihang Technology CoLtd.

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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.