With its stock down 37% over the past three months, it is easy to disregard Shanghai Shen Lian Biomedical (SHSE:688098). To decide if this trend could continue, we decided to look at its weak fundamentals as they shape the long-term market trends. Specifically, we decided to study Shanghai Shen Lian Biomedical'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 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 Shanghai Shen Lian Biomedical is:

2.1% = CN¥32m ÷ CN¥1.5b (Based on the trailing twelve months to December 2023).

The 'return' is the amount earned after tax 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¥0.02 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. 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.

Shanghai Shen Lian Biomedical's Earnings Growth And 2.1% ROE

As you can see, Shanghai Shen Lian Biomedical's ROE looks pretty weak. Even when compared to the industry average of 8.2%, the ROE figure is pretty disappointing. Therefore, it might not be wrong to say that the five year net income decline of 17% seen by Shanghai Shen Lian Biomedical was possibly a result of it having a lower ROE. However, there could also be other factors causing the earnings to decline. For instance, the company has a very high payout ratio, or is faced with competitive pressures.

That being said, we compared Shanghai Shen Lian Biomedical'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. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is Shanghai Shen Lian Biomedical fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Shanghai Shen Lian Biomedical Using Its Retained Earnings Effectively?

With a high three-year median payout ratio of 51% (implying that 49% of the profits are retained), most of Shanghai Shen Lian Biomedical's profits are being paid to shareholders, which explains the company's shrinking earnings. With only very little left to reinvest into the business, growth in earnings is far from likely. Our risks dashboard should have the 3 risks we have identified for Shanghai Shen Lian Biomedical.

Additionally, Shanghai Shen Lian Biomedical has paid dividends over a period of four years, which means that the company's management is rather focused on keeping up its dividend payments, regardless of the shrinking earnings.

Conclusion

Overall, we would be extremely cautious before making any decision on Shanghai Shen Lian Biomedical. As a result of its low ROE and lack of much reinvestment into the business, the company has seen a disappointing earnings growth rate. Until now, we have only just grazed the surface of the company's past performance by looking at the company's fundamentals. To gain further insights into Shanghai Shen Lian Biomedical's past profit growth, check out this visualization of past earnings, revenue and cash flows.

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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.