Most readers would already be aware that Shandong Xinhua Pharmaceutical's (HKG:719) stock increased significantly by 64% over the past three months. 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. Particularly, we will be paying attention to Shandong Xinhua Pharmaceutical's ROE today.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. Put another way, it reveals the company's success at turning shareholder investments into profits.

View our latest analysis for Shandong Xinhua Pharmaceutical

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 Shandong Xinhua Pharmaceutical is:

9.0% = CN¥366m ÷ CN¥4.0b (Based on the trailing twelve months to March 2022).

The 'return' is the profit over the last twelve months. That means that for every HK$1 worth of shareholders' equity, the company generated HK$0.09 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. 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.

Shandong Xinhua Pharmaceutical's Earnings Growth And 9.0% ROE

When you first look at it, Shandong Xinhua Pharmaceutical's ROE doesn't look that attractive. However, given that the company's ROE is similar to the average industry ROE of 11%, we may spare it some thought. Having said that, Shandong Xinhua Pharmaceutical has shown a modest net income growth of 14% over the past five years. Considering the moderately low ROE, it is quite possible that there might be some other aspects that are positively influencing the company's earnings growth. For instance, the company has a low payout ratio or is being managed efficiently.

Next, on comparing Shandong Xinhua Pharmaceutical's net income growth with the industry, we found that the company's reported growth is similar to the industry average growth rate of 12% 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. Doing so will help them establish if the stock's future looks promising or ominous. Is Shandong Xinhua Pharmaceutical fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Shandong Xinhua Pharmaceutical Making Efficient Use Of Its Profits?

In Shandong Xinhua Pharmaceutical's case, its respectable earnings growth can probably be explained by its low three-year median payout ratio of 25% (or a retention ratio of 75%), which suggests that the company is investing most of its profits to grow its business.

Moreover, Shandong Xinhua Pharmaceutical is determined to keep sharing its profits with shareholders which we infer from its long history of paying a dividend for at least ten years.

Conclusion

In total, it does look like Shandong Xinhua Pharmaceutical has some positive aspects to its business. Even in spite of the low rate of return, the company has posted impressive earnings growth as a result of reinvesting heavily into its 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. You can see the 2 risks we have identified for Shandong Xinhua Pharmaceutical by visiting our risks dashboard for free on our platform here.

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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.