Most readers would already be aware that Changchun Zhiyuan New Energy Equipment's (SZSE:300985) stock increased significantly by 39% over the past three months. However, we wonder if the company's inconsistent financials would have any adverse impact on the current share price momentum. In this article, we decided to focus on Changchun Zhiyuan New Energy Equipment'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 Do You 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 Changchun Zhiyuan New Energy Equipment is:

7.5% = CN¥91m ÷ CN¥1.2b (Based on the trailing twelve months to September 2024).

The 'return' refers to a company's earnings over the last year. So, this means that for every CN¥1 of its shareholder's investments, the company generates a profit of CN¥0.07.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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. 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.

Changchun Zhiyuan New Energy Equipment's Earnings Growth And 7.5% ROE

When you first look at it, Changchun Zhiyuan New Energy Equipment's ROE doesn't look that attractive. However, given that the company's ROE is similar to the average industry ROE of 6.3%, we may spare it some thought. But Changchun Zhiyuan New Energy Equipment saw a five year net income decline of 27% over the past five years. Remember, the company's ROE is a bit low to begin with. So that's what might be causing earnings growth to shrink.

That being said, we compared Changchun Zhiyuan New Energy Equipment'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 7.3% in the same 5-year period.

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. 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 Changchun Zhiyuan New Energy Equipment is trading on a high P/E or a low P/E, relative to its industry.

Is Changchun Zhiyuan New Energy Equipment Efficiently Re-investing Its Profits?

In spite of a normal three-year median payout ratio of 40% (that is, a retention ratio of 60%), the fact that Changchun Zhiyuan New Energy Equipment'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.

In addition, Changchun Zhiyuan New Energy Equipment has been paying dividends over a period of three years suggesting that keeping up dividend payments is preferred by the management even though earnings have been in decline.

Conclusion

Overall, we have mixed feelings about Changchun Zhiyuan New Energy Equipment. While the company does have a high rate of reinvestment, the low ROE means that all that reinvestment is not reaping any benefit to its investors, and moreover, its having a negative impact on the 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. Our risks dashboard would have the 5 risks we have identified for Changchun Zhiyuan New Energy Equipment.

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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.