Most readers would already be aware that Zhe Jiang Headman MachineryLtd's (SHSE:688577) stock increased significantly by 41% over the past three months. But the company's key financial indicators appear to be differing across the board and that makes us question whether or not the company's current share price momentum can be maintained. Specifically, we decided to study Zhe Jiang Headman MachineryLtd's ROE in this article.

ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

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 Zhe Jiang Headman MachineryLtd is:

2.5% = CN¥25m ÷ CN¥1.0b (Based on the trailing twelve months to September 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¥0.02.

What Is The Relationship Between ROE And Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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.

Zhe Jiang Headman MachineryLtd's Earnings Growth And 2.5% ROE

As you can see, Zhe Jiang Headman MachineryLtd's ROE looks pretty weak. Even when compared to the industry average of 6.3%, the ROE figure is pretty disappointing. Therefore, it might not be wrong to say that the five year net income decline of 12% seen by Zhe Jiang Headman MachineryLtd was possibly a result of it having a lower ROE. We reckon that there could also be other factors at play here. Such as - low earnings retention or poor allocation of capital.

So, as a next step, we compared Zhe Jiang Headman MachineryLtd's performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 7.3% over the last few years.

Earnings growth is a huge factor in stock valuation. It's important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). Doing so will help them establish if the stock's future looks promising or ominous. If you're wondering about Zhe Jiang Headman MachineryLtd's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Zhe Jiang Headman MachineryLtd Making Efficient Use Of Its Profits?

In spite of a normal three-year median payout ratio of 36% (that is, a retention ratio of 64%), the fact that Zhe Jiang Headman MachineryLtd's earnings have shrunk is quite puzzling. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.

Moreover, Zhe Jiang Headman MachineryLtd has been paying dividends for four years, which is a considerable amount of time, suggesting that management must have perceived that the shareholders prefer consistent dividends even though earnings have been shrinking.

Summary

Overall, we have mixed feelings about Zhe Jiang Headman MachineryLtd. Even though it appears to be retaining most of its profits, given the low ROE, investors may not be benefitting from all that reinvestment after all. The low earnings growth suggests our theory correct. 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. You can see the 6 risks we have identified for Zhe Jiang Headman MachineryLtd by visiting our risks dashboard for free on our platform here.

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.