Most readers would already be aware that Chongqing Zongshen Power MachineryLtd's (SZSE:001696) stock increased significantly by 20% 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. Particularly, we will be paying attention to Chongqing Zongshen Power MachineryLtd'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. Put another way, it reveals the company's success at turning shareholder investments into profits.

How Is ROE Calculated?

The formula for ROE is:

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

So, based on the above formula, the ROE for Chongqing Zongshen Power MachineryLtd is:

7.2% = CN¥384m ÷ CN¥5.4b (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.

What Has ROE Got To Do With 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.

Chongqing Zongshen Power MachineryLtd's Earnings Growth And 7.2% ROE

On the face of it, Chongqing Zongshen Power MachineryLtd's ROE is not much to talk about. However, its ROE is similar to the industry average of 8.2%, so we won't completely dismiss the company. But Chongqing Zongshen Power MachineryLtd saw a five year net income decline of 3.9% over the past five years. Bear in mind, the company does have a slightly low ROE. Hence, this goes some way in explaining the shrinking earnings.

So, as a next step, we compared Chongqing Zongshen Power MachineryLtd'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 8.9% over the last few years.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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. If you're wondering about Chongqing Zongshen Power MachineryLtd's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Chongqing Zongshen Power MachineryLtd Making Efficient Use Of Its Profits?

Chongqing Zongshen Power MachineryLtd has a high three-year median payout ratio of 72% (that is, it is retaining 28% of its profits). This suggests that the company is paying most of its profits as dividends to its shareholders. This goes some way in explaining why its earnings have been shrinking. 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 2 risks we have identified for Chongqing Zongshen Power MachineryLtd by visiting our risks dashboard for free on our platform here.

Additionally, Chongqing Zongshen Power MachineryLtd has paid dividends over a period of at least ten years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth.

Summary

In total, we would have a hard think before deciding on any investment action concerning Chongqing Zongshen Power MachineryLtd. The company has seen a lack of earnings growth as a result of retaining very little profits and whatever little it does retain, is being reinvested at a very low rate of return. 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 latest analysts predictions for the company, check out this visualization of analyst forecasts 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.