Shanghai Hollywave Electronic System's (SHSE:688682) stock is up by a considerable 27% over the past three months. However, we decided to pay attention to the company's fundamentals which don't appear to give a clear sign about the company's financial health. Specifically, we decided to study Shanghai Hollywave Electronic System's ROE in this article.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. Put another way, it reveals the company's success at turning shareholder investments into profits.

How Do You 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 Shanghai Hollywave Electronic System is:

5.0% = CN¥35m ÷ CN¥684m (Based on the trailing twelve months to June 2024).

The 'return' is the amount earned after tax over the last twelve months. Another way to think of that is that for every CN¥1 worth of equity, the company was able to earn CN¥0.05 in profit.

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. 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. 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.

Shanghai Hollywave Electronic System's Earnings Growth And 5.0% ROE

When you first look at it, Shanghai Hollywave Electronic System's ROE doesn't look that attractive. However, its ROE is similar to the industry average of 4.5%, so we won't completely dismiss the company. But Shanghai Hollywave Electronic System saw a five year net income decline of 6.9% over the past five years. Bear in mind, the company does have a slightly low ROE. So that's what might be causing earnings growth to shrink.

That being said, we compared Shanghai Hollywave Electronic System's performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 0.8% in the same 5-year period.

Earnings growth is a huge factor in stock valuation. 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 Shanghai Hollywave Electronic System is trading on a high P/E or a low P/E, relative to its industry.

Is Shanghai Hollywave Electronic System Efficiently Re-investing Its Profits?

In spite of a normal three-year median payout ratio of 35% (that is, a retention ratio of 65%), the fact that Shanghai Hollywave Electronic System's earnings have shrunk is quite puzzling. So there could be some other explanations in that regard. For instance, the company's business may be deteriorating.

Only recently, Shanghai Hollywave Electronic System stated paying a dividend. This likely means that the management might have concluded that its shareholders have a strong preference for dividends.

Summary

On the whole, we feel that the performance shown by Shanghai Hollywave Electronic System can be open to many interpretations. While the company does have a high rate of profit retention, its low rate of return is probably hampering its earnings growth. Wrapping up, we would proceed with caution with this company and one way of doing that would be to look at the risk profile of the business. To know the 4 risks we have identified for Shanghai Hollywave Electronic System visit our risks dashboard for free.

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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.