With its stock down 24% over the past three months, it is easy to disregard Zhejiang Changhua Auto Parts (SHSE:605018). We, however decided to study the company's financials to determine if they have got anything to do with the price decline. Fundamentals usually dictate market outcomes so it makes sense to study the company's financials. In this article, we decided to focus on Zhejiang Changhua Auto Parts' 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 other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

See our latest analysis for Zhejiang Changhua Auto Parts

How Is ROE Calculated?

The formula for ROE 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:

3.7% = CN¥98m ÷ CN¥2.7b (Based on the trailing twelve months to June 2022).

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¥0.04 in profit.

What Has ROE Got To Do With 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 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.

Zhejiang Changhua Auto Parts' Earnings Growth And 3.7% ROE

It is quite clear that Zhejiang Changhua Auto Parts' ROE is rather low. Not just that, even compared to the industry average of 6.4%, the company's ROE is entirely unremarkable. Therefore, it might not be wrong to say that the five year net income decline of 7.9% seen by Zhejiang Changhua Auto Parts was possibly a result of it having a lower ROE. We reckon that there could also be other factors at play here. For example, the business has allocated capital poorly, or that the company has a very high payout ratio.

So, as a next step, we compared Zhejiang Changhua Auto Parts' performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 1.7% 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. If you're wondering about Zhejiang Changhua Auto Parts''s valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Zhejiang Changhua Auto Parts Making Efficient Use Of Its Profits?

Looking at its three-year median payout ratio of 41% (or a retention ratio of 59%) which is pretty normal, Zhejiang Changhua Auto Parts' declining earnings is rather baffling as one would expect to see a fair bit of growth when a company is retaining a good portion of its profits. So there could be some other explanations in that regard. For instance, the company's business may be deteriorating.

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. Our risks dashboard would have the 4 risks we have identified for Zhejiang Changhua Auto Parts.

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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.