Wells Advanced Materials (Shanghai) (SZSE:301555) has had a great run on the share market with its stock up by a significant 22% over the last week. We wonder if and what role the company's financials play in that price change as a company's long-term fundamentals usually dictate market outcomes. Specifically, we decided to study Wells Advanced Materials (Shanghai)'s ROE in this article.

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. 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 Wells Advanced Materials (Shanghai) is:

2.1% = CN¥22m ÷ CN¥1.1b (Based on the trailing twelve months to June 2024).

The 'return' is the yearly profit. Another way to think of that is that for every CN¥1 worth of equity, the company was able to earn CN¥0.02 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. 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 all else is equal, companies that have both a higher return on equity and higher profit retention are usually the ones that have a higher growth rate when compared to companies that don't have the same features.

Wells Advanced Materials (Shanghai)'s Earnings Growth And 2.1% ROE

It is hard to argue that Wells Advanced Materials (Shanghai)'s ROE is much good in and of itself. Even when compared to the industry average of 6.4%, the ROE figure is pretty disappointing. Wells Advanced Materials (Shanghai) was still able to see a decent net income growth of 11% over the past five years. Therefore, the growth in earnings could probably have been caused by other variables. Such as - high earnings retention or an efficient management in place.

Next, on comparing with the industry net income growth, we found that Wells Advanced Materials (Shanghai)'s growth is quite high when compared to the industry average growth of 6.3% 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 Wells Advanced Materials (Shanghai) is trading on a high P/E or a low P/E, relative to its industry.

Is Wells Advanced Materials (Shanghai) Making Efficient Use Of Its Profits?

With a three-year median payout ratio of 37% (implying that the company retains 63% of its profits), it seems that Wells Advanced Materials (Shanghai) is reinvesting efficiently in a way that it sees respectable amount growth in its earnings and pays a dividend that's well covered.

Conclusion

On the whole, we do feel that Wells Advanced Materials (Shanghai) has some positive attributes. With a high rate of reinvestment, albeit at a low ROE, the company has managed to see a considerable growth in its earnings. While we won't completely dismiss the company, what we would do, is try to ascertain how risky the business is to make a more informed decision around the company. Our risks dashboard would have the 3 risks we have identified for Wells Advanced Materials (Shanghai).

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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.