Hangzhou Hikvision Digital Technology's (SZSE:002415) stock is up by a considerable 12% over the past month. We wonder if and what role the company's financials play in that price change as a company's long-term fundamentals usually dictate market outcomes. In this article, we decided to focus on Hangzhou Hikvision Digital Technology's ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors' money. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

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 Hangzhou Hikvision Digital Technology is:

19% = CN¥14b ÷ CN¥73b (Based on the trailing twelve months to December 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¥0.19 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.

Hangzhou Hikvision Digital Technology's Earnings Growth And 19% ROE

To start with, Hangzhou Hikvision Digital Technology's ROE looks acceptable. On comparing with the average industry ROE of 6.7% the company's ROE looks pretty remarkable. However, for some reason, the higher returns aren't reflected in Hangzhou Hikvision Digital Technology's meagre five year net income growth average of 4.2%. This is interesting as the high returns should mean that the company has the ability to generate high growth but for some reason, it hasn't been able to do so. We reckon that a low growth, when returns are quite high could be the result of certain circumstances like low earnings retention or poor allocation of capital.

As a next step, we compared Hangzhou Hikvision Digital Technology's net income growth with the industry and were disappointed to see that the company's growth is lower than the industry average growth of 11% in the same period.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Has the market priced in the future outlook for 002415? You can find out in our latest intrinsic value infographic research report.

Is Hangzhou Hikvision Digital Technology Efficiently Re-investing Its Profits?

The high three-year median payout ratio of 52% (that is, the company retains only 48% of its income) over the past three years for Hangzhou Hikvision Digital Technology suggests that the company's earnings growth was lower as a result of paying out a majority of its earnings.

In addition, Hangzhou Hikvision Digital Technology 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. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 26% over the next three years. The fact that the company's ROE is expected to rise to 25% over the same period is explained by the drop in the payout ratio.

Conclusion

In total, it does look like Hangzhou Hikvision Digital Technology has some positive aspects to its business. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE. Bear in mind, the company reinvests a small portion of its profits, which means that investors aren't reaping the benefits of the high rate of return. With that said, the latest industry analyst forecasts reveal that the company's earnings are expected to accelerate. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page 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.