It is hard to get excited after looking at China Tobacco International (HK)'s (HKG:6055) recent performance, when its stock has declined 23% over the past three months. But if you pay close attention, you might find that its key financial indicators look quite decent, which could mean that the stock could potentially rise in the long-term given how markets usually reward more resilient long-term fundamentals. In this article, we decided to focus on China Tobacco International (HK)'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. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

Check out our latest analysis for China Tobacco International (HK)

How To 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 China Tobacco International (HK) is:

36% = HK$717m ÷ HK$2.0b (Based on the trailing twelve months to December 2021).

The 'return' is the yearly profit. So, this means that for every HK$1 of its shareholder's investments, the company generates a profit of HK$0.36.

What Has ROE Got To Do With Earnings Growth?

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

China Tobacco International (HK)'s Earnings Growth And 36% ROE

First thing first, we like that China Tobacco International (HK) has an impressive ROE. Additionally, the company's ROE is higher compared to the industry average of 6.2% which is quite remarkable. Despite this, China Tobacco International (HK)'s five year net income growth was quite low averaging at only 3.8%. 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. A few likely reasons why this could happen is that the company could have a high payout ratio or the business has allocated capital poorly, for instance.

Next, on comparing with the industry net income growth, we found that China Tobacco International (HK)'s reported growth was lower than the industry growth of 6.8% in the same period, which is not something we like to see.

Earnings growth is an important metric to consider when valuing a stock. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. 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 China Tobacco International (HK) is trading on a high P/E or a low P/E, relative to its industry.

Is China Tobacco International (HK) Making Efficient Use Of Its Profits?

Despite having a moderate three-year median payout ratio of 26% (implying that the company retains the remaining 74% of its income), China Tobacco International (HK)'s earnings growth was quite low. Therefore, there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.

Additionally, China Tobacco International (HK) started paying a dividend only recently. So it looks like the management must have perceived that shareholders favor dividends over earnings growth. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 28% of its profits over the next three years. However, China Tobacco International (HK)'s future ROE is expected to decline to 14% despite there being not much change anticipated in the company's payout ratio.

Summary

In total, it does look like China Tobacco International (HK) has some positive aspects to its business. Yet, the low earnings growth is a bit concerning, especially given that the company has a high rate of return and is reinvesting ma huge portion of its profits. By the looks of it, there could be some other factors, not necessarily in control of the business, that's preventing growth. That being so, according to the latest industry analyst forecasts, the company's earnings are expected to shrink 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.