It is hard to get excited after looking at Lihuayi Weiyuan Chemical's (SHSE:600955) recent performance, when its stock has declined 26% over the past three months. It seems that the market might have completely ignored the positive aspects of the company's fundamentals and decided to weigh-in more on the negative aspects. Fundamentals usually dictate market outcomes so it makes sense to study the company's financials. Specifically, we decided to study Lihuayi Weiyuan Chemical'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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

How Do You Calculate Return On Equity?

The formula for return on equity is:

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

So, based on the above formula, the ROE for Lihuayi Weiyuan Chemical is:

2.4% = CN¥204m ÷ CN¥8.6b (Based on the trailing twelve months to September 2023).

The 'return' is the profit over the last twelve months. One way to conceptualize this is that for each CN¥1 of shareholders' capital it has, the company made CN¥0.02 in profit.

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 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.

A Side By Side comparison of Lihuayi Weiyuan Chemical's Earnings Growth And 2.4% ROE

As you can see, Lihuayi Weiyuan Chemical's ROE looks pretty weak. Not just that, even compared to the industry average of 6.9%, the company's ROE is entirely unremarkable. Therefore, Lihuayi Weiyuan Chemical's flat earnings over the past five years can possibly be explained by the low ROE amongst other factors.

We then compared Lihuayi Weiyuan Chemical's net income growth with the industry and found that the average industry growth rate was 12% 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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is Lihuayi Weiyuan Chemical fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Lihuayi Weiyuan Chemical Efficiently Re-investing Its Profits?

Lihuayi Weiyuan Chemical has a low three-year median payout ratio of 21% (or a retention ratio of 79%) but the negligible earnings growth number doesn't reflect this as high growth usually follows high profit retention.

Only recently, Lihuayi Weiyuan Chemical started paying a dividend. This means that the management might have concluded that its shareholders prefer dividends over earnings growth. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 15% over the next three years. As a result, the expected drop in Lihuayi Weiyuan Chemical's payout ratio explains the anticipated rise in the company's future ROE to 8.9%, over the same period.

Summary

In total, we're a bit ambivalent about Lihuayi Weiyuan Chemical's performance. While the company does have a high rate of profit retention, its low rate of return is probably hampering its earnings growth. 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 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.