Zhejiang Changhua Auto Parts (SHSE:605018) has had a rough three months with its share price down 20%. We, however decided to study the company's financials to determine if they have got anything to do with the price decline. 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. Specifically, we decided to study Zhejiang Changhua Auto Parts' ROE in this article.

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 short, ROE shows the profit each dollar generates with respect to its shareholder investments.

Check out our latest analysis for Zhejiang Changhua Auto Parts

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 Zhejiang Changhua Auto Parts is:

5.5% = CN¥154m ÷ CN¥2.8b (Based on the trailing twelve months to March 2022).

The 'return' refers to a company's earnings over the last year. So, this means that for every CN¥1 of its shareholder's investments, the company generates a profit of CN¥0.06.

What Has ROE Got To Do With 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 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.

A Side By Side comparison of Zhejiang Changhua Auto Parts' Earnings Growth And 5.5% ROE

On the face of it, Zhejiang Changhua Auto Parts' ROE is not much to talk about. Yet, a closer study shows that the company's ROE is similar to the industry average of 6.7%. But Zhejiang Changhua Auto Parts saw a five year net income decline of 4.1% over the past five years. Remember, the company's ROE is a bit low to begin with. So that's what might be causing earnings growth to shrink.

That being said, we compared Zhejiang Changhua Auto Parts' 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 1.5% in the same period.

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 Zhejiang Changhua Auto Parts is trading on a high P/E or a low P/E, relative to its industry.

Is Zhejiang Changhua Auto Parts Efficiently Re-investing Its Profits?

In spite of a normal three-year median payout ratio of 40% (that is, a retention ratio of 60%), the fact that Zhejiang Changhua Auto Parts' earnings have shrunk is quite puzzling. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.

Only recently, Zhejiang Changhua Auto Parts stated paying a dividend. This likely means that the management might have concluded that its shareholders have a strong preference for dividends.

Summary

Overall, we have mixed feelings about Zhejiang Changhua Auto Parts. While the company does have a high rate of reinvestment, the low ROE means that all that reinvestment is not reaping any benefit to its investors, and moreover, its having a negative impact on the earnings growth. 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. To know the 5 risks we have identified for Zhejiang Changhua Auto Parts visit our risks dashboard for free.

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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.