Zhejiang Fulai New MaterialLtd (SHSE:605488) has had a great run on the share market with its stock up by a significant 41% over the last month. But the company's key financial indicators appear to be differing across the board and that makes us question whether or not the company's current share price momentum can be maintained. Specifically, we decided to study Zhejiang Fulai New MaterialLtd's ROE in this article.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

How To Calculate Return On Equity?

Return on equity 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 Fulai New MaterialLtd is:

6.4% = CN¥73m ÷ CN¥1.1b (Based on the trailing twelve months to September 2023).

The 'return' is the profit over the last twelve months. Another way to think of that is that for every CN¥1 worth of equity, the company was able to earn CN¥0.06 in profit.

Why Is ROE Important For Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. 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.

A Side By Side comparison of Zhejiang Fulai New MaterialLtd's Earnings Growth And 6.4% ROE

On the face of it, Zhejiang Fulai New MaterialLtd's ROE is not much to talk about. Yet, a closer study shows that the company's ROE is similar to the industry average of 7.0%. But then again, Zhejiang Fulai New MaterialLtd's five year net income shrunk at a rate of 7.6%. Remember, the company's ROE is a bit low to begin with. Therefore, the decline in earnings could also be the result of this.

However, when we compared Zhejiang Fulai New MaterialLtd's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 12% in the same period. This is quite worrisome.

Earnings growth is an important metric to consider when valuing a stock. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. This then helps them determine if the stock is placed for a bright or bleak future. 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 Fulai New MaterialLtd is trading on a high P/E or a low P/E, relative to its industry.

Is Zhejiang Fulai New MaterialLtd Using Its Retained Earnings Effectively?

Looking at its three-year median payout ratio of 48% (or a retention ratio of 52%) which is pretty normal, Zhejiang Fulai New MaterialLtd's 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.

Additionally, Zhejiang Fulai New MaterialLtd started paying a dividend only recently. So it looks like the management may have perceived that shareholders favor dividends even though earnings have been in decline.

Conclusion

In total, we're a bit ambivalent about Zhejiang Fulai New MaterialLtd's performance. 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. You can see the 5 risks we have identified for Zhejiang Fulai New MaterialLtd 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.