Most readers would already know that Challenger Technologies' (SGX:573) stock increased by 7.9% over the past three months. Given that the stock prices usually follow long-term business performance, we wonder if the company's mixed financials could have any adverse effect on its current price price movement In this article, we decided to focus on Challenger Technologies' ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

Check out our latest analysis for Challenger Technologies

How To Calculate Return On Equity?

ROE can be calculated by using the formula:

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

So, based on the above formula, the ROE for Challenger Technologies is:

5.9% = S$9.4m ÷ S$160m (Based on the trailing twelve months to December 2022).

The 'return' is the yearly profit. Another way to think of that is that for every SGD1 worth of equity, the company was able to earn SGD0.06 in profit.

What Is The Relationship Between ROE And 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 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.

Challenger Technologies' Earnings Growth And 5.9% ROE

At first glance, Challenger Technologies' ROE doesn't look very promising. A quick further study shows that the company's ROE doesn't compare favorably to the industry average of 10% either. Given the circumstances, the significant decline in net income by 4.1% seen by Challenger Technologies over the last five years is not surprising. We believe that there also might be other aspects that are negatively influencing the company's earnings prospects. For instance, the company has a very high payout ratio, or is faced with competitive pressures.

That being said, we compared Challenger Technologies' 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 14% in the same period.

Earnings growth is a huge factor in stock valuation. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. 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 Challenger Technologies is trading on a high P/E or a low P/E, relative to its industry.

Is Challenger Technologies 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, Challenger Technologies' 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.

Moreover, Challenger Technologies has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over earnings growth.

Summary

Overall, we have mixed feelings about Challenger Technologies. While the company does have a high rate of profit retention, its low rate of return is probably hampering its 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 2 risks we have identified for Challenger Technologies.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.

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