Changzhou Xiangming Intelligent Drive System's (SZSE:301226) stock is up by a considerable 79% over the past month. 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 Changzhou Xiangming Intelligent Drive System'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 Do You 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 Changzhou Xiangming Intelligent Drive System is:

3.5% = CN¥32m ÷ CN¥910m (Based on the trailing twelve months to March 2024).

The 'return' is the profit over the last twelve months. That means that for every CN¥1 worth of shareholders' equity, the company generated CN¥0.03 in profit.

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.

Changzhou Xiangming Intelligent Drive System's Earnings Growth And 3.5% ROE

It is quite clear that Changzhou Xiangming Intelligent Drive System's ROE is rather low. Even when compared to the industry average of 6.9%, the ROE figure is pretty disappointing. For this reason, Changzhou Xiangming Intelligent Drive System's five year net income decline of 13% is not surprising given its lower ROE. We reckon that there could also be other factors at play here. For instance, the company has a very high payout ratio, or is faced with competitive pressures.

However, when we compared Changzhou Xiangming Intelligent Drive System's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 12% in the same period. This is quite worrisome.

Earnings growth is an important metric to consider when valuing a stock. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. Doing so will help them establish if the stock's future looks promising or ominous. Is Changzhou Xiangming Intelligent Drive System fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Changzhou Xiangming Intelligent Drive System Efficiently Re-investing Its Profits?

With a high three-year median payout ratio of 59% (implying that 41% of the profits are retained), most of Changzhou Xiangming Intelligent Drive System's profits are being paid to shareholders, which explains the company's shrinking earnings. The business is only left with a small pool of capital to reinvest - A vicious cycle that doesn't benefit the company in the long-run. You can see the 4 risks we have identified for Changzhou Xiangming Intelligent Drive System by visiting our risks dashboard for free on our platform here.

Additionally, Changzhou Xiangming Intelligent Drive System 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.

Conclusion

Overall, we would be extremely cautious before making any decision on Changzhou Xiangming Intelligent Drive System. 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. Until now, we have only just grazed the surface of the company's past performance by looking at the company's fundamentals. To gain further insights into Changzhou Xiangming Intelligent Drive System's past profit growth, check out this visualization of past earnings, revenue and cash flows.

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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