Weichai Heavy Machinery's (SZSE:000880) stock is up by a considerable 28% over the past three months. Given that the market rewards strong financials in the long-term, we wonder if that is the case in this instance. In this article, we decided to focus on Weichai Heavy Machinery's ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors' money. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

How To Calculate Return On Equity?

ROE can be calculated by using the formula:

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

So, based on the above formula, the ROE for Weichai Heavy Machinery is:

8.5% = CN¥174m ÷ CN¥2.0b (Based on the trailing twelve months to June 2024).

The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each CN¥1 of shareholders' capital it has, the company made CN¥0.09 in profit.

Why Is ROE Important For Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. 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.

A Side By Side comparison of Weichai Heavy Machinery's Earnings Growth And 8.5% ROE

When you first look at it, Weichai Heavy Machinery's ROE doesn't look that attractive. However, the fact that the company's ROE is higher than the average industry ROE of 7.0%, is definitely interesting. Consequently, this likely laid the ground for the decent growth of 18% seen over the past five years by Weichai Heavy Machinery. Bear in mind, the company does have a moderately low ROE. It is just that the industry ROE is lower. Therefore, the growth in earnings could also be the result of other factors. E.g the company has a low payout ratio or could belong to a high growth industry.

We then compared Weichai Heavy Machinery's net income growth with the industry and we're pleased to see that the company's growth figure is higher when compared with the industry which has a growth rate of 8.8% in the same 5-year period.

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. 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 Weichai Heavy Machinery is trading on a high P/E or a low P/E, relative to its industry.

Is Weichai Heavy Machinery Efficiently Re-investing Its Profits?

With a three-year median payout ratio of 31% (implying that the company retains 69% of its profits), it seems that Weichai Heavy Machinery is reinvesting efficiently in a way that it sees respectable amount growth in its earnings and pays a dividend that's well covered.

Besides, Weichai Heavy Machinery has been paying dividends over a period of seven years. This shows that the company is committed to sharing profits with its shareholders.

Summary

Overall, we are quite pleased with Weichai Heavy Machinery's performance. Specifically, we like that it has been reinvesting a high portion of its profits at a moderate rate of return, resulting in earnings expansion. If the company continues to grow its earnings the way it has, that could have a positive impact on its share price given how earnings per share influence long-term share prices. Remember, the price of a stock is also dependent on the perceived risk. Therefore investors must keep themselves informed about the risks involved before investing in any company. Our risks dashboard would have the 2 risks we have identified for Weichai Heavy Machinery.

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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.