It is hard to get excited after looking at Shanghai Dazhong Public Utilities(Group)Ltd's (SHSE:600635) recent performance, when its stock has declined 5.0% over the past week. It is possible that the markets have ignored the company's differing financials and decided to lean-in to the negative sentiment. Stock prices are usually driven by a company's financial performance over the long term, and therefore we decided to pay more attention to the company's financial performance. Particularly, we will be paying attention to Shanghai Dazhong Public Utilities(Group)Ltd'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 Is ROE Calculated?

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 Dazhong Public Utilities(Group)Ltd is:

3.1% = CN¥304m ÷ CN¥9.7b (Based on the trailing twelve months to December 2023).

The 'return' refers to a company's earnings over the last year. Another way to think of that is that for every CN¥1 worth of equity, the company was able to earn CN¥0.03 in profit.

Why Is ROE Important For Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. 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 Dazhong Public Utilities(Group)Ltd's Earnings Growth And 3.1% ROE

It is hard to argue that Shanghai Dazhong Public Utilities(Group)Ltd's ROE is much good in and of itself. Even compared to the average industry ROE of 9.6%, the company's ROE is quite dismal. For this reason, Shanghai Dazhong Public Utilities(Group)Ltd's five year net income decline of 32% is not surprising given its lower ROE. We reckon that there could also be other factors at play here. Such as - low earnings retention or poor allocation of capital.

That being said, we compared Shanghai Dazhong Public Utilities(Group)Ltd'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 6.8% in the same 5-year period.

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). By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. 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 Dazhong Public Utilities(Group)Ltd is trading on a high P/E or a low P/E, relative to its industry.

Is Shanghai Dazhong Public Utilities(Group)Ltd Using Its Retained Earnings Effectively?

In spite of a normal three-year median payout ratio of 32% (that is, a retention ratio of 68%), the fact that Shanghai Dazhong Public Utilities(Group)Ltd's earnings have shrunk is quite puzzling. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.

In addition, Shanghai Dazhong Public Utilities(Group)Ltd has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth.

Summary

On the whole, we feel that the performance shown by Shanghai Dazhong Public Utilities(Group)Ltd can be open to many interpretations. 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. You can see the 4 risks we have identified for Shanghai Dazhong Public Utilities(Group)Ltd 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.