With its stock down 19% over the past three months, it is easy to disregard Shanghai Aohua Photoelectricity Endoscope (SHSE:688212). 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 Aohua Photoelectricity Endoscope'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 short, ROE shows the profit each dollar generates with respect to its shareholder investments.

How Do You 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 Aohua Photoelectricity Endoscope is:

3.3% = CN¥47m ÷ CN¥1.4b (Based on the trailing twelve months to March 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¥0.03 in profit.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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. 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.

A Side By Side comparison of Shanghai Aohua Photoelectricity Endoscope's Earnings Growth And 3.3% ROE

It is hard to argue that Shanghai Aohua Photoelectricity Endoscope's ROE is much good in and of itself. Not just that, even compared to the industry average of 7.4%, the company's ROE is entirely unremarkable. Thus, the low net income growth of 3.3% seen by Shanghai Aohua Photoelectricity Endoscope over the past five years could probably be the result of it having a lower ROE.

As a next step, we compared Shanghai Aohua Photoelectricity Endoscope's net income growth with the industry and were disappointed to see that the company's growth is lower than the industry average growth of 5.8% in the same period.

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 Aohua Photoelectricity Endoscope is trading on a high P/E or a low P/E, relative to its industry.

Is Shanghai Aohua Photoelectricity Endoscope Making Efficient Use Of Its Profits?

Despite having a moderate three-year median payout ratio of 50% (implying that the company retains the remaining 50% of its income), Shanghai Aohua Photoelectricity Endoscope's earnings growth was quite low. So there could be some other explanation in that regard. For instance, the company's business may be deteriorating.

Only recently, Shanghai Aohua Photoelectricity Endoscope started paying a dividend. This means that the management might have concluded that its shareholders prefer dividends over earnings growth. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 14% over the next three years. As a result, the expected drop in Shanghai Aohua Photoelectricity Endoscope's payout ratio explains the anticipated rise in the company's future ROE to 12%, over the same period.

Summary

In total, we're a bit ambivalent about Shanghai Aohua Photoelectricity Endoscope's performance. While the company does have a high rate of profit retention, its low rate of return is probably hampering its earnings growth. Having said that, looking at the current analyst estimates, we found that the company's earnings are expected to gain momentum. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.

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