Renhe Pharmacy's (SZSE:000650) stock is up by a considerable 8.6% over the past month. Given that stock prices are usually aligned with a company's financial performance in the long-term, we decided to study its financial indicators more closely to see if they had a hand to play in the recent price move. In this article, we decided to focus on Renhe Pharmacy's ROE.

ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

How Is ROE Calculated?

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 Renhe Pharmacy is:

12% = CN¥797m ÷ CN¥6.8b (Based on the trailing twelve months to September 2023).

The 'return' is the yearly profit. That means that for every CN¥1 worth of shareholders' equity, the company generated CN¥0.12 in profit.

What Is The Relationship Between ROE And Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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.

Renhe Pharmacy's Earnings Growth And 12% ROE

To begin with, Renhe Pharmacy seems to have a respectable ROE. On comparing with the average industry ROE of 8.3% the company's ROE looks pretty remarkable. Despite this, Renhe Pharmacy's five year net income growth was quite low averaging at only 4.9%. 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. Such a scenario is likely to take place when a company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.

We then compared Renhe Pharmacy's net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 11% in the same 5-year period, which is a bit concerning.

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). Doing so will help them establish if the stock's future looks promising or ominous. 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 Renhe Pharmacy is trading on a high P/E or a low P/E, relative to its industry.

Is Renhe Pharmacy Using Its Retained Earnings Effectively?

Despite having a normal three-year median payout ratio of 40% (or a retention ratio of 60% over the past three years, Renhe Pharmacy has seen very little growth in earnings as we saw above. Therefore, there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.

Moreover, Renhe Pharmacy has been paying dividends for nine years, which is a considerable amount of time, suggesting that management must have perceived that the shareholders prefer dividends over earnings growth.

Summary

On the whole, we do feel that Renhe Pharmacy 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. While we won't completely dismiss the company, what we would do, is try to ascertain how risky the business is to make a more informed decision around the company. Our risks dashboard will have the 1 risk we have identified for Renhe Pharmacy.

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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.