Kunshan Asia Aroma's (SZSE:301220) stock is up by a considerable 19% over the past 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. In this article, we decided to focus on Kunshan Asia Aroma's ROE.

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. 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 return on equity is:

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

So, based on the above formula, the ROE for Kunshan Asia Aroma is:

4.8% = CN¥76m ÷ CN¥1.6b (Based on the trailing twelve months to March 2024).

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¥0.05 in profit.

Why Is ROE Important For Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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.

Kunshan Asia Aroma's Earnings Growth And 4.8% ROE

It is quite clear that Kunshan Asia Aroma's ROE is rather low. Not just that, even compared to the industry average of 6.3%, the company's ROE is entirely unremarkable. Thus, the low net income growth of 2.9% seen by Kunshan Asia Aroma over the past five years could probably be the result of it having a lower ROE.

As a next step, we compared Kunshan Asia Aroma'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 8.8% in the same period.

Earnings growth is a huge factor in stock valuation. It's important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is Kunshan Asia Aroma fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Kunshan Asia Aroma Using Its Retained Earnings Effectively?

Kunshan Asia Aroma has a low three-year median payout ratio of 19% (meaning, the company keeps the remaining 81% of profits) which means that the company is retaining more of its earnings. However, the low earnings growth number doesn't reflect this fact. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.

Additionally, Kunshan Asia Aroma started paying a dividend only recently. So it looks like the management must have perceived that shareholders favor dividends over earnings growth. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 8.6% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 11%, over the same period.

Conclusion

In total, we're a bit ambivalent about Kunshan Asia Aroma's performance. 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. That being so, the latest analyst forecasts show that the company will continue to see an expansion in its earnings. 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.