Guangzhou Tongda Auto Electric Co., Ltd's (SHSE:603390) On An Uptrend But Financial Prospects Look Pretty Weak: Is The Stock Overpriced?

Guangzhou Tongda Auto Electric (SHSE:603390) has had a great run on the share market with its stock up by a significant 19% over the last week. However, we decided to pay close attention to its weak financials as we are doubtful that the current momentum will keep up, given the scenario. In this article, we decided to focus on Guangzhou Tongda Auto Electric's ROE.

ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

View our latest analysis for Guangzhou Tongda Auto Electric

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 Guangzhou Tongda Auto Electric is:

1.6% = CN¥25m ÷ CN¥1.6b (Based on the trailing twelve months to March 2024).

The 'return' is the amount earned after tax over the last twelve months. That means that for every CN¥1 worth of shareholders' equity, the company generated CN¥0.02 in profit.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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 all else is equal, companies that have both a higher return on equity and higher profit retention are usually the ones that have a higher growth rate when compared to companies that don't have the same features.

A Side By Side comparison of Guangzhou Tongda Auto Electric's Earnings Growth And 1.6% ROE

As you can see, Guangzhou Tongda Auto Electric's ROE looks pretty weak. Even compared to the average industry ROE of 8.1%, the company's ROE is quite dismal. Given the circumstances, the significant decline in net income by 64% seen by Guangzhou Tongda Auto Electric over the last five years is not surprising. However, there could also be other factors causing the earnings to decline. For example, the business has allocated capital poorly, or that the company has a very high payout ratio.

So, as a next step, we compared Guangzhou Tongda Auto Electric's performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 8.4% over the last few years.

Earnings growth is an important metric to consider when valuing a stock. 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. 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 Guangzhou Tongda Auto Electric is trading on a high P/E or a low P/E, relative to its industry.

Is Guangzhou Tongda Auto Electric Efficiently Re-investing Its Profits?

With a high three-year median payout ratio of 71% (implying that 29% of the profits are retained), most of Guangzhou Tongda Auto Electric'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.

In addition, Guangzhou Tongda Auto Electric has been paying dividends over a period of four years suggesting that keeping up dividend payments is preferred by the management even though earnings have been in decline.

Conclusion

Overall, we would be extremely cautious before making any decision on Guangzhou Tongda Auto Electric. Because the company is not reinvesting much into the business, and given the low ROE, it's not surprising to see the lack or absence of growth in its earnings. Up till now, we've only made a short study of the company's growth data. To gain further insights into Guangzhou Tongda Auto Electric'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.