It is hard to get excited after looking at Weichai Power's (HKG:2338) recent performance, when its stock has declined 22% over the past three months. But if you pay close attention, you might find that its key financial indicators look quite decent, which could mean that the stock could potentially rise in the long-term given how markets usually reward more resilient long-term fundamentals. In this article, we decided to focus on Weichai Power'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 Is ROE Calculated?

The formula for ROE is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Weichai Power is:

11% = CN¥14b ÷ CN¥121b (Based on the trailing twelve months to September 2024).

The 'return' is the profit over the last twelve months. That means that for every HK$1 worth of shareholders' equity, the company generated HK$0.11 in profit.

What Has ROE Got To Do With Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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.

A Side By Side comparison of Weichai Power's Earnings Growth And 11% ROE

To begin with, Weichai Power seems to have a respectable ROE. And on comparing with the industry, we found that the the average industry ROE is similar at 12%. Despite this, Weichai Power's five year net income growth was quite flat over the past five years. We reckon that there could be some other factors at play here that's limiting the company's growth. Such as, the company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.

Next, on comparing with the industry net income growth, we found that the industry grew its earnings by 11% over the last few years.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. It's important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). 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 Weichai Power is trading on a high P/E or a low P/E, relative to its industry.

Is Weichai Power Using Its Retained Earnings Effectively?

In spite of a normal three-year median payout ratio of 46% (or a retention ratio of 54%), Weichai Power hasn't seen much growth in its earnings. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.

Additionally, Weichai Power has paid dividends over a period of at least ten years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth. Our latest analyst data shows that the future payout ratio of the company is expected to rise to 55% over the next three years. Regardless, the future ROE for Weichai Power is speculated to rise to 14% despite the anticipated increase in the payout ratio. There could probably be other factors that could be driving the future growth in the ROE.

Conclusion

On the whole, we do feel that Weichai Power has some positive attributes. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE and and a high reinvestment rate. We believe that there might be some outside factors that could be having a negative impact on the business. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts 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.