Rainbow Digital Commercial (SZSE:002419) has had a great run on the share market with its stock up by a significant 28% over the last three months. 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. In this article, we decided to focus on Rainbow Digital Commercial's ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors' money. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

How Is ROE Calculated?

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 Rainbow Digital Commercial is:

2.9% = CN¥122m ÷ CN¥4.2b (Based on the trailing twelve months to September 2024).

The 'return' refers to a company's earnings over the last year. Another way to think of that is that for every CN¥1 worth of equity, the company was able to earn CN¥0.03 in profit.

What Has ROE Got To Do With 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.

Rainbow Digital Commercial's Earnings Growth And 2.9% ROE

It is quite clear that Rainbow Digital Commercial's ROE is rather low. Even when compared to the industry average of 3.7%, the ROE figure is pretty disappointing. Therefore, it might not be wrong to say that the five year net income decline of 36% seen by Rainbow Digital Commercial was possibly a result of it having a lower ROE. However, there could also be other factors causing the earnings to decline. For example, the business has allocated capital poorly, or that the company has a very high payout ratio.

As a next step, we compared Rainbow Digital Commercial's performance with the industry and found thatRainbow Digital Commercial's performance is depressing even when compared with the industry, which has shrunk its earnings at a rate of 13% in the same period, which is a slower than the company.

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. What is 002419 worth today? The intrinsic value infographic in our free research report helps visualize whether 002419 is currently mispriced by the market.

Is Rainbow Digital Commercial Making Efficient Use Of Its Profits?

Rainbow Digital Commercial's declining earnings is not surprising given how the company is spending most of its profits in paying dividends, judging by its three-year median payout ratio of 82% (or a retention ratio of 18%). With only very little left to reinvest into the business, growth in earnings is far from likely. To know the 3 risks we have identified for Rainbow Digital Commercial visit our risks dashboard for free.

Moreover, Rainbow Digital Commercial has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over earnings growth.

Conclusion

In total, we would have a hard think before deciding on any investment action concerning Rainbow Digital Commercial. As a result of its low ROE and lack of much reinvestment into the business, the company has seen a disappointing earnings growth rate. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page for the company.

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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.