Most readers would already be aware that YiChang HEC ChangJiang Pharmaceutical's (HKG:1558) stock increased significantly by 16% over the past three months. Given that stock prices are usually aligned with a company's financial performance in the long-term, we decided to study its financial indicators more closely to see if they had a hand to play in the recent price move. Particularly, we will be paying attention to YiChang HEC ChangJiang Pharmaceutical's ROE today.

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

How Do You Calculate Return On Equity?

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 YiChang HEC ChangJiang Pharmaceutical is:

18% = CN¥1.5b ÷ CN¥8.7b (Based on the trailing twelve months to June 2024).

The 'return' refers to a company's earnings over the last year. So, this means that for every HK$1 of its shareholder's investments, the company generates a profit of HK$0.18.

Why Is ROE Important For Earnings Growth?

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

YiChang HEC ChangJiang Pharmaceutical's Earnings Growth And 18% ROE

To start with, YiChang HEC ChangJiang Pharmaceutical's ROE looks acceptable. Especially when compared to the industry average of 11% the company's ROE looks pretty impressive. Needless to say, we are quite surprised to see that YiChang HEC ChangJiang Pharmaceutical's net income shrunk at a rate of 2.1% over the past five years. We reckon that there could be some other factors at play here that are preventing the company's growth. These include low earnings retention or poor allocation of capital.

So, as a next step, we compared YiChang HEC ChangJiang Pharmaceutical'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 4.3% over the last few years.

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. Is YiChang HEC ChangJiang Pharmaceutical fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is YiChang HEC ChangJiang Pharmaceutical Using Its Retained Earnings Effectively?

YiChang HEC ChangJiang Pharmaceutical doesn't pay any regular dividends, meaning that potentially all of its profits are being reinvested in the business, which doesn't explain why the company's earnings have shrunk if it is retaining all 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.

Summary

On the whole, we do feel that YiChang HEC ChangJiang Pharmaceutical has some positive attributes. However, given the high ROE and high profit retention, we would expect the company to be delivering strong earnings growth, but that isn't the case here. This suggests that there might be some external threat to the business, that's hampering its growth. While we won't completely dismiss the company, what we would do, is try to ascertain how risky the business is to make a more informed decision around the company. You can see the 2 risks we have identified for YiChang HEC ChangJiang Pharmaceutical by visiting our risks dashboard for free on our platform here.

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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.