Inspur Software (SHSE:600756) has had a great run on the share market with its stock up by a significant 13% over the last week. 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 Inspur Software's ROE in this article.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors' money. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

How To 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 Inspur Software is:

3.9% = CN¥92m ÷ CN¥2.3b (Based on the trailing twelve months to December 2023).

The 'return' is the profit over the last twelve months. Another way to think of that is that for every CN¥1 worth of equity, the company was able to earn CN¥0.04 in profit.

Why Is ROE Important For 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.

Inspur Software's Earnings Growth And 3.9% ROE

It is hard to argue that Inspur Software's ROE is much good in and of itself. A comparison with the industry shows that the company's ROE is pretty similar to the average industry ROE of 3.9%. Therefore, it might not be wrong to say that the five year net income decline of 28% seen by Inspur Software was possibly a result of the disappointing ROE.

That being said, we compared Inspur Software'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 1.7% in the same 5-year period.

Earnings growth is an important metric to consider when valuing a stock. It's important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). This then helps them determine if the stock is placed for a bright or bleak future. 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 Inspur Software is trading on a high P/E or a low P/E, relative to its industry.

Is Inspur Software Using Its Retained Earnings Effectively?

When we piece together Inspur Software's low three-year median payout ratio of 13% (where it is retaining 88% of its profits), calculated for the last three-year period, we are puzzled by the lack of growth. The low payout should mean that the company is retaining most of its earnings and consequently, should see some growth. So there might be other factors at play here which could potentially be hampering growth. For instance, the business has faced some headwinds.

In addition, Inspur Software 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

Overall, we have mixed feelings about Inspur Software. While the company does have a high rate of reinvestment, the low ROE means that all that reinvestment is not reaping any benefit to its investors, and moreover, its having a negative impact on the earnings growth. 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 1 risk we have identified for Inspur Software 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.