Xinlei Compressor's (SZSE:301317) stock is up by a considerable 41% over the past month. We, however wanted to have a closer look at its key financial indicators as the markets usually pay for long-term fundamentals, and in this case, they don't look very promising. Specifically, we decided to study Xinlei Compressor's ROE in this article.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors' money. Put another way, it reveals the company's success at turning shareholder investments into profits.

How Do You Calculate Return On Equity?

The formula for ROE is:

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

So, based on the above formula, the ROE for Xinlei Compressor is:

6.6% = CN¥68m ÷ CN¥1.0b (Based on the trailing twelve months to June 2024).

The 'return' is the amount earned after tax over the last twelve months. So, this means that for every CN¥1 of its shareholder's investments, the company generates a profit of CN¥0.07.

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. 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.

A Side By Side comparison of Xinlei Compressor's Earnings Growth And 6.6% ROE

At first glance, Xinlei Compressor's ROE doesn't look very promising. However, given that the company's ROE is similar to the average industry ROE of 6.8%, we may spare it some thought. On the other hand, Xinlei Compressor reported a fairly low 2.1% net income growth over the past five years. Bear in mind, the company's ROE is not very high . Hence, this does provide some context to low earnings growth seen by the company.

As a next step, we compared Xinlei Compressor's net income growth with the industry and were disappointed to see that the company's growth is lower than the industry average growth of 8.4% in the same 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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. 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 Xinlei Compressor is trading on a high P/E or a low P/E, relative to its industry.

Is Xinlei Compressor Using Its Retained Earnings Effectively?

With a high three-year median payout ratio of 67% (or a retention ratio of 33%), most of Xinlei Compressor's profits are being paid to shareholders. This definitely contributes to the low earnings growth seen by the company.

Only recently, Xinlei Compressor started paying a dividend. This means that the management might have concluded that its shareholders prefer dividends over earnings growth.

Summary

In total, we would have a hard think before deciding on any investment action concerning Xinlei Compressor. As a result of its low ROE and lack of much reinvestment into the business, the company has seen a disappointing earnings growth rate. In brief, we think the company is risky and investors should think twice before making any final judgement on this company. Our risks dashboard would have the 3 risks we have identified for Xinlei Compressor.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.