It is hard to get excited after looking at Pony Testing's (SZSE:300887) recent performance, when its stock has declined 27% 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. In this article, we decided to focus on Pony Testing's ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors' money. Put another way, it reveals the company's success at turning shareholder investments into profits.

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 Pony Testing is:

7.1% = CN¥248m ÷ CN¥3.5b (Based on the trailing twelve months to September 2023).

The 'return' refers to a company's earnings over the last year. That means that for every CN¥1 worth of shareholders' equity, the company generated CN¥0.07 in profit.

What Has ROE Got To Do With Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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 everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.

Pony Testing's Earnings Growth And 7.1% ROE

When you first look at it, Pony Testing's ROE doesn't look that attractive. However, given that the company's ROE is similar to the average industry ROE of 7.0%, we may spare it some thought. Looking at Pony Testing's exceptional 24% five-year net income growth in particular, we are definitely impressed. Given the slightly low ROE, it is likely that there could be some other aspects that are driving this growth. Such as - high earnings retention or an efficient management in place.

As a next step, we compared Pony Testing's net income growth with the industry, and pleasingly, we found that the growth seen by the company is higher than the average industry growth of 3.8%.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. It's important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). 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 Pony Testing is trading on a high P/E or a low P/E, relative to its industry.

Is Pony Testing Making Efficient Use Of Its Profits?

Pony Testing's three-year median payout ratio to shareholders is 21%, which is quite low. This implies that the company is retaining 79% of its profits. So it looks like Pony Testing is reinvesting profits heavily to grow its business, which shows in its earnings growth.

Moreover, Pony Testing is determined to keep sharing its profits with shareholders which we infer from its long history of three years of paying a dividend. Looking at the current analyst consensus data, we can see that the company's future payout ratio is expected to rise to 30% over the next three years. Regardless, the future ROE for Pony Testing is speculated to rise to 11% despite the anticipated increase in the payout ratio. There could probably be other factors that could be driving the future growth in the ROE.

Conclusion

In total, it does look like Pony Testing has some positive aspects to its business. Even in spite of the low rate of return, the company has posted impressive earnings growth as a result of reinvesting heavily into its business. Having said that, looking at the current analyst estimates, we found that the company's earnings are expected to gain momentum. 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.