Shanghai Mechanical & Electrical IndustryLtd (SHSE:600835) has had a great run on the share market with its stock up by a significant 66% over the last three months. 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. Particularly, we will be paying attention to Shanghai Mechanical & Electrical IndustryLtd's ROE today.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

How Do You Calculate Return On Equity?

Return on equity 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 Mechanical & Electrical IndustryLtd is:

8.6% = CN¥1.4b ÷ CN¥16b (Based on the trailing twelve months to September 2024).

The 'return' is the income the business earned 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¥0.09 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. 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 everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.

A Side By Side comparison of Shanghai Mechanical & Electrical IndustryLtd's Earnings Growth And 8.6% ROE

At first glance, Shanghai Mechanical & Electrical IndustryLtd's ROE doesn't look very promising. Although a closer study shows that the company's ROE is higher than the industry average of 6.3% which we definitely can't overlook. But seeing Shanghai Mechanical & Electrical IndustryLtd's five year net income decline of 4.1% over the past five years, we might rethink that. Bear in mind, the company does have a slightly low ROE. It is just that the industry ROE is lower. Therefore, the decline in earnings could also be the result of this.

That being said, we compared Shanghai Mechanical & Electrical IndustryLtd'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.

Earnings growth is a huge factor in stock valuation. 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. Is Shanghai Mechanical & Electrical IndustryLtd fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Shanghai Mechanical & Electrical IndustryLtd Making Efficient Use Of Its Profits?

Looking at its three-year median payout ratio of 45% (or a retention ratio of 55%) which is pretty normal, Shanghai Mechanical & Electrical IndustryLtd's declining earnings is rather baffling as one would expect to see a fair bit of growth when a company is retaining a good portion of its profits. It looks like there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.

In addition, Shanghai Mechanical & Electrical IndustryLtd has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth.

Conclusion

In total, it does look like Shanghai Mechanical & Electrical IndustryLtd has some positive aspects to its business. However, while the company does have a decent ROE and a high profit retention, its earnings growth number is quite disappointing. This suggests that there might be some external threat to the business, that's hampering growth. That being so, the latest industry analyst forecasts show that the analysts are expecting to see a huge improvement in the company's earnings growth rate. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.

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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.