With its stock down 32% over the past three months, it is easy to disregard ChangZhou KAIDI Electrical (SHSE:605288). 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. Stock prices are usually driven by a company's financial performance over the long term, and therefore we decided to pay more attention to the company's financial performance. Particularly, we will be paying attention to ChangZhou KAIDI Electrical's ROE today.

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 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 ChangZhou KAIDI Electrical is:

4.3% = CN¥93m ÷ CN¥2.2b (Based on the trailing twelve months to September 2023).

The 'return' is the yearly profit. One way to conceptualize this is that for each CN¥1 of shareholders' capital it has, the company made 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. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. 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 ChangZhou KAIDI Electrical's Earnings Growth And 4.3% ROE

It is hard to argue that ChangZhou KAIDI Electrical's ROE is much good in and of itself. Even compared to the average industry ROE of 7.2%, the company's ROE is quite dismal. Given the circumstances, the significant decline in net income by 29% seen by ChangZhou KAIDI Electrical over the last five years is not surprising. We reckon that there could also be other factors at play here. Such as - low earnings retention or poor allocation of capital.

That being said, we compared ChangZhou KAIDI Electrical'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 14% in the same 5-year period.

Earnings growth is a huge factor in stock valuation. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. This then helps them determine if the stock is placed for a bright or bleak future. If you're wondering about ChangZhou KAIDI Electrical's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is ChangZhou KAIDI Electrical Using Its Retained Earnings Effectively?

Looking at its three-year median payout ratio of 32% (or a retention ratio of 68%) which is pretty normal, ChangZhou KAIDI Electrical's declining earnings is rather baffling as one would expect to see a fair bit of growth when a company is retaining a good portion of its profits. So there could be some other explanations in that regard. For instance, the company's business may be deteriorating.

Moreover, ChangZhou KAIDI Electrical has been paying dividends for three 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.

Conclusion

On the whole, we feel that the performance shown by ChangZhou KAIDI Electrical can be open to many interpretations. 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 2 risks we have identified for ChangZhou KAIDI Electrical 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.