With its stock down 14% over the past three months, it is easy to disregard Shenzhen SED Industry (SZSE:000032). We, however decided to study the company's financials to determine if they have got anything to do with the price decline. Fundamentals usually dictate market outcomes so it makes sense to study the company's financials. In this article, we decided to focus on Shenzhen SED Industry's ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors' money. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

How To Calculate Return On Equity?

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 Shenzhen SED Industry is:

7.5% = CN¥896m ÷ CN¥12b (Based on the trailing twelve months to March 2024).

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¥0.07 in profit.

Why Is ROE Important For Earnings Growth?

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

A Side By Side comparison of Shenzhen SED Industry's Earnings Growth And 7.5% ROE

On the face of it, Shenzhen SED Industry's ROE is not much to talk about. Yet, a closer study shows that the company's ROE is similar to the industry average of 7.3%. But then again, Shenzhen SED Industry's five year net income shrunk at a rate of 15%. Remember, the company's ROE is a bit low to begin with. Hence, this goes some way in explaining the shrinking earnings.

However, when we compared Shenzhen SED Industry's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 7.8% in the same period. This is quite worrisome.

Earnings growth is a huge factor in stock valuation. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is Shenzhen SED Industry fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Shenzhen SED Industry Efficiently Re-investing Its Profits?

Looking at its three-year median payout ratio of 34% (or a retention ratio of 66%) which is pretty normal, Shenzhen SED Industry's declining earnings is rather baffling as one would expect to see a fair bit of growth when a company is retaining a good portion of its profits. So there could be some other explanations in that regard. For instance, the company's business may be deteriorating.

Additionally, Shenzhen SED Industry started paying a dividend only recently. So it looks like the management may have perceived that shareholders favor dividends even though earnings have been in decline. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 25% over the next three years. However, the company's ROE is not expected to change by much despite the lower expected payout ratio.

Conclusion

Overall, we have mixed feelings about Shenzhen SED Industry. 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. That being so, the latest industry analyst forecasts show that the analysts are expecting to see a huge improvement in the company's earnings growth rate. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page 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.

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