Perfect World (SZSE:002624) has had a rough three months with its share price down 22%. We decided to study the company's financials to determine if the downtrend will continue as the long-term performance of a company usually dictates market outcomes. Particularly, we will be paying attention to Perfect World's ROE today.

ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

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 Perfect World is:

4.1% = CN¥388m ÷ CN¥9.4b (Based on the trailing twelve months to March 2024).

The 'return' is the profit over the last twelve months. One way to conceptualize this is that for each CN¥1 of shareholders' capital it has, the company made CN¥0.04 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 everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.

Perfect World's Earnings Growth And 4.1% ROE

It is hard to argue that Perfect World's ROE is much good in and of itself. Even when compared to the industry average of 5.6%, the ROE figure is pretty disappointing. Given the circumstances, the significant decline in net income by 27% seen by Perfect World over the last five years is not surprising. We believe that there also might be other aspects that are negatively influencing the company's earnings prospects. Such as - low earnings retention or poor allocation of capital.

However, when we compared Perfect World's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 4.8% in the same period. This is quite worrisome.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Has the market priced in the future outlook for 002624? You can find out in our latest intrinsic value infographic research report.

Is Perfect World Using Its Retained Earnings Effectively?

Perfect World's high three-year median payout ratio of 123% suggests that the company is depleting its resources to keep up its dividend payments, and this shows in its shrinking earnings. Paying a dividend beyond their means is usually not viable over the long term. You can see the 3 risks we have identified for Perfect World by visiting our risks dashboard for free on our platform here.

Additionally, Perfect World has paid dividends over a period of nine years, which means that the company's management is rather focused on keeping up its dividend payments, regardless of the shrinking earnings. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 105% of its profits over the next three years. Still, forecasts suggest that Perfect World's future ROE will rise to 12% even though the the company's payout ratio is not expected to change by much.

Conclusion

In total, we would have a hard think before deciding on any investment action concerning Perfect World. Specifically, it has shown quite an unsatisfactory performance as far as earnings growth is concerned, and a poor ROE and an equally poor rate of reinvestment seem to be the reason behind this inadequate performance. 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. 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.

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