Shanghai TianchenLtd (SHSE:600620) has had a great run on the share market with its stock up by a significant 8.9% over the last week. But the company's key financial indicators appear to be differing across the board and that makes us question whether or not the company's current share price momentum can be maintained. Specifically, we decided to study Shanghai TianchenLtd's ROE in this article.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

Check out our latest analysis for Shanghai TianchenLtd

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 Shanghai TianchenLtd is:

4.7% = CN¥96m ÷ CN¥2.1b (Based on the trailing twelve months to June 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¥0.05 in profit.

What Is The Relationship Between ROE And 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 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.

Shanghai TianchenLtd's Earnings Growth And 4.7% ROE

As you can see, Shanghai TianchenLtd's ROE looks pretty weak. A comparison with the industry shows that the company's ROE is pretty similar to the average industry ROE of 4.0%. Given the low ROE Shanghai TianchenLtd's five year net income decline of 7.8% is not surprising.

Next, on comparing with the industry net income growth, we found that Shanghai TianchenLtd's earnings seems to be shrinking at a similar rate as the industry which shrunk at a rate of a rate of 7.3% in the same 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). 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 TianchenLtd is trading on a high P/E or a low P/E, relative to its industry.

Is Shanghai TianchenLtd Efficiently Re-investing Its Profits?

Despite having a normal three-year median payout ratio of 26% (where it is retaining 74% of its profits), Shanghai TianchenLtd has seen a decline in earnings as we saw above. So there could be some other explanations in that regard. For instance, the company's business may be deteriorating.

Moreover, Shanghai TianchenLtd 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

In total, we're a bit ambivalent about Shanghai TianchenLtd's performance. Even though it appears to be retaining most of its profits, given the low ROE, investors may not be benefitting from all that reinvestment after all. The low earnings growth suggests our theory correct. 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 2 risks we have identified for Shanghai TianchenLtd.

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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.