Most readers would already be aware that Tonghua Dongbao Pharmaceutical's (SHSE:600867) stock increased significantly by 16% over the past three months. However, in this article, we decided to focus on its weak fundamentals, as long-term financial performance of a business is what ultimately dictates market outcomes. Specifically, we decided to study Tonghua Dongbao Pharmaceutical's ROE in this article.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors' money. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

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 Tonghua Dongbao Pharmaceutical is:

5.3% = CN¥341m ÷ CN¥6.4b (Based on the trailing twelve months to September 2024).

The 'return' is the yearly profit. So, this means that for every CN¥1 of its shareholder's investments, the company generates a profit of CN¥0.05.

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. 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. 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.

Tonghua Dongbao Pharmaceutical's Earnings Growth And 5.3% ROE

At first glance, Tonghua Dongbao Pharmaceutical's ROE doesn't look very promising. We then compared the company's ROE to the broader industry and were disappointed to see that the ROE is lower than the industry average of 7.7%. Therefore, Tonghua Dongbao Pharmaceutical's flat earnings over the past five years can possibly be explained by the low ROE amongst other factors.

We then compared Tonghua Dongbao Pharmaceutical's net income growth with the industry and found that the average industry growth rate was 9.1% in the same 5-year period.

Earnings growth is an important metric to consider when valuing a stock. It's important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). This then helps them determine if the stock is placed for a bright or bleak future. 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 Tonghua Dongbao Pharmaceutical is trading on a high P/E or a low P/E, relative to its industry.

Is Tonghua Dongbao Pharmaceutical Using Its Retained Earnings Effectively?

The high three-year median payout ratio of 57% (meaning, the company retains only 43% of profits) for Tonghua Dongbao Pharmaceutical suggests that the company's earnings growth was miniscule as a result of paying out a majority of its earnings.

Moreover, Tonghua Dongbao Pharmaceutical 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

On the whole, Tonghua Dongbao Pharmaceutical's performance is quite a big let-down. Because the company is not reinvesting much into the business, and given the low ROE, it's not surprising to see the lack or absence of growth in its earnings. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts 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.