It is hard to get excited after looking at Colorlight Cloud Tech's (SZSE:301391) recent performance, when its stock has declined 44% over the past three months. However, a closer look at its sound financials might cause you to think again. Given that fundamentals usually drive long-term market outcomes, the company is worth looking at. Particularly, we will be paying attention to Colorlight Cloud Tech's ROE today.

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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.

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 Colorlight Cloud Tech is:

7.7% = CN¥164m ÷ CN¥2.1b (Based on the trailing twelve months to September 2023).

The 'return' is the yearly profit. So, this means that for every CN¥1 of its shareholder's investments, the company generates a profit of CN¥0.08.

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. Depending on how much of these profits the company reinvests or "retains", and how effectively it does so, we are then able to assess a company's earnings growth potential. 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.

Colorlight Cloud Tech's Earnings Growth And 7.7% ROE

At first glance, Colorlight Cloud Tech's ROE doesn't look very promising. However, the fact that the its ROE is quite higher to the industry average of 6.2% doesn't go unnoticed by us. Particularly, the substantial 26% net income growth seen by Colorlight Cloud Tech over the past five years is impressive . That being said, the company does have a slightly low ROE to begin with, just that it is higher than the industry average. So, there might well be other reasons for the earnings to grow. Such as- high earnings retention or the company belonging to a high growth industry.

Next, on comparing with the industry net income growth, we found that Colorlight Cloud Tech's growth is quite high when compared to the industry average growth of 5.7% in the same period, which is great to see.

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. This then helps them determine if the stock is placed for a bright or bleak future. 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 Colorlight Cloud Tech is trading on a high P/E or a low P/E, relative to its industry.

Is Colorlight Cloud Tech Efficiently Re-investing Its Profits?

Colorlight Cloud Tech's three-year median payout ratio is a pretty moderate 34%, meaning the company retains 66% of its income. So it seems that Colorlight Cloud Tech is reinvesting efficiently in a way that it sees impressive growth in its earnings (discussed above) and pays a dividend that's well covered.

Along with seeing a growth in earnings, Colorlight Cloud Tech only recently started paying dividends. Its quite possible that the company was looking to impress its shareholders. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 5.6% over the next three years. As a result, the expected drop in Colorlight Cloud Tech's payout ratio explains the anticipated rise in the company's future ROE to 15%, over the same period.

Summary

Overall, we are quite pleased with Colorlight Cloud Tech's performance. In particular, it's great to see that the company has seen significant growth in its earnings backed by a respectable ROE and a high reinvestment rate. With that said, the latest industry analyst forecasts reveal that the company's earnings are expected to accelerate. 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.