Most readers would already know that Yunnan Baiyao GroupLtd's (SZSE:000538) stock increased by 5.1% 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 investigate if the company's decent financials had a hand to play in the recent price move. Specifically, we decided to study Yunnan Baiyao GroupLtd's ROE in this article.

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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

How Is ROE Calculated?

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 Yunnan Baiyao GroupLtd is:

12% = CN¥4.8b ÷ CN¥40b (Based on the trailing twelve months to September 2023).

The 'return' is the income the business earned over the last year. That means that for every CN¥1 worth of shareholders' equity, the company generated CN¥0.12 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. 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.

Yunnan Baiyao GroupLtd's Earnings Growth And 12% ROE

At first glance, Yunnan Baiyao GroupLtd seems to have a decent ROE. On comparing with the average industry ROE of 8.3% the company's ROE looks pretty remarkable. Needless to say, we are quite surprised to see that Yunnan Baiyao GroupLtd's net income shrunk at a rate of 2.7% over the past five years. We reckon that there could be some other factors at play here that are preventing the company's growth. For example, it could be that the company has a high payout ratio or the business has allocated capital poorly, for instance.

That being said, we compared Yunnan Baiyao GroupLtd's 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 11% 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). Doing so will help them establish if the stock's future looks promising or ominous. If you're wondering about Yunnan Baiyao GroupLtd's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Yunnan Baiyao GroupLtd Making Efficient Use Of Its Profits?

Yunnan Baiyao GroupLtd's declining earnings is not surprising given how the company is spending most of its profits in paying dividends, judging by its three-year median payout ratio of 78% (or a retention ratio of 22%). With only a little being reinvested into the business, earnings growth would obviously be low or non-existent.

Moreover, Yunnan Baiyao GroupLtd 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. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 73%. As a result, Yunnan Baiyao GroupLtd's ROE is not expected to change by much either, which we inferred from the analyst estimate of 12% for future ROE.

Summary

In total, it does look like Yunnan Baiyao GroupLtd has some positive aspects to its business. Yet, the low earnings growth is a bit concerning, especially given that the company has a high rate of return. Investors could have benefitted from the high ROE, had the company been reinvesting more of its earnings. As discussed earlier, the company is retaining a small portion of its profits. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page for the company.

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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.