ArcSoft (SHSE:688088) has had a great run on the share market with its stock up by a significant 59% over the last 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. In this article, we decided to focus on ArcSoft's ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors' money. Put another way, it reveals the company's success at turning shareholder investments into profits.

How Is ROE Calculated?

The formula for return on equity is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for ArcSoft is:

3.7% = CN¥96m ÷ CN¥2.6b (Based on the trailing twelve months to September 2024).

The 'return' is the amount earned after tax over the last twelve months. Another way to think of that is that for every CN¥1 worth of equity, the company was able to earn CN¥0.04 in profit.

Why Is ROE Important For Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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.

ArcSoft's Earnings Growth And 3.7% ROE

As you can see, ArcSoft's ROE looks pretty weak. An industry comparison shows that the company's ROE is not much different from the industry average of 4.5% either. Therefore, it might not be wrong to say that the five year net income decline of 27% seen by ArcSoft was possibly a result of the disappointing ROE.

So, as a next step, we compared ArcSoft's performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 1.1% over the last few years.

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. If you're wondering about ArcSoft's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is ArcSoft Using Its Retained Earnings Effectively?

ArcSoft's declining earnings is not surprising given how the company is spending most of its profits in paying dividends, judging by its three-year median payout ratio of 89% (or a retention ratio of 11%). With only a little being reinvested into the business, earnings growth would obviously be low or non-existent. Our risks dashboard should have the 2 risks we have identified for ArcSoft.

In addition, ArcSoft has been paying dividends over a period of five years suggesting that keeping up dividend payments is preferred by the management even though earnings have been in decline. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 99%. Regardless, the future ROE for ArcSoft is predicted to rise to 7.7% despite there being not much change expected in its payout ratio.

Conclusion

On the whole, ArcSoft'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 company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.

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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.