It is hard to get excited after looking at Zhejiang Guanghua TechnologyLtd's (SZSE:001333) recent performance, when its stock has declined 24% over the past three months. However, the company's fundamentals look pretty decent, and long-term financials are usually aligned with future market price movements. Particularly, we will be paying attention to Zhejiang Guanghua TechnologyLtd's ROE today.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors' money. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

How Is ROE Calculated?

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 Zhejiang Guanghua TechnologyLtd is:

7.5% = CN¥117m ÷ CN¥1.6b (Based on the trailing twelve months to September 2023).

The 'return' is the yearly profit. Another way to think of that is that for every CN¥1 worth of equity, the company was able to earn CN¥0.07 in profit.

What Is The Relationship Between ROE And Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don't share these attributes.

Zhejiang Guanghua TechnologyLtd's Earnings Growth And 7.5% ROE

On the face of it, Zhejiang Guanghua TechnologyLtd's ROE is not much to talk about. However, its ROE is similar to the industry average of 6.9%, so we won't completely dismiss the company. Having said that, Zhejiang Guanghua TechnologyLtd has shown a modest net income growth of 13% over the past five years. Taking into consideration that the ROE is not particularly high, we reckon that there could also be other factors at play which could be influencing the company's growth. For example, it is possible that the company's management has made some good strategic decisions, or that the company has a low payout ratio.

We then performed a comparison between Zhejiang Guanghua TechnologyLtd's net income growth with the industry, which revealed that the company's growth is similar to the average industry growth of 12% in the same 5-year 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. 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 Guanghua TechnologyLtd is trading on a high P/E or a low P/E, relative to its industry.

Is Zhejiang Guanghua TechnologyLtd Using Its Retained Earnings Effectively?

Zhejiang Guanghua TechnologyLtd has a three-year median payout ratio of 44%, which implies that it retains the remaining 56% of its profits. This suggests that its dividend is well covered, and given the decent growth seen by the company, it looks like management is reinvesting its earnings efficiently.

Along with seeing a growth in earnings, Zhejiang Guanghua TechnologyLtd only recently started paying dividends. Its quite possible that the company was looking to impress its shareholders.

Conclusion

Overall, we feel that Zhejiang Guanghua TechnologyLtd certainly does have some positive factors to consider. With a high rate of reinvestment, albeit at a low ROE, the company has managed to see a considerable growth in its earnings. 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. Our risks dashboard would have the 2 risks we have identified for Zhejiang Guanghua TechnologyLtd.

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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.