Xuchang Yuandong Drive Shaft Co.Ltd's (SZSE:002406) Stock's Been Going Strong: Could Weak Financials Mean The Market Will Correct Its Share Price?

Xuchang Yuandong Drive ShaftLtd's (SZSE:002406) stock is up by a considerable 42% over the past three months. 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 Xuchang Yuandong Drive ShaftLtd's ROE.

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. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

See our latest analysis for Xuchang Yuandong Drive ShaftLtd

How To Calculate Return On Equity?

The formula for ROE is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Xuchang Yuandong Drive ShaftLtd is:

2.9% = CN¥118m ÷ CN¥4.0b (Based on the trailing twelve months to September 2024).

The 'return' is the yearly profit. One way to conceptualize this is that for each CN¥1 of shareholders' capital it has, the company made CN¥0.03 in profit.

What Has ROE Got To Do With Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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.

Xuchang Yuandong Drive ShaftLtd's Earnings Growth And 2.9% ROE

It is quite clear that Xuchang Yuandong Drive ShaftLtd's ROE is rather low. Not just that, even compared to the industry average of 8.3%, the company's ROE is entirely unremarkable. Therefore, it might not be wrong to say that the five year net income decline of 29% seen by Xuchang Yuandong Drive ShaftLtd was possibly a result of it having a lower ROE. We reckon that there could also be other factors at play here. For instance, the company has a very high payout ratio, or is faced with competitive pressures.

That being said, we compared Xuchang Yuandong Drive ShaftLtd'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 9.2% in the same 5-year period.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. If you're wondering about Xuchang Yuandong Drive ShaftLtd's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Xuchang Yuandong Drive ShaftLtd Using Its Retained Earnings Effectively?

Xuchang Yuandong Drive ShaftLtd'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 71% (or a retention ratio of 29%). With only a little being reinvested into the business, earnings growth would obviously be low or non-existent. To know the 3 risks we have identified for Xuchang Yuandong Drive ShaftLtd visit our risks dashboard for free.

In addition, Xuchang Yuandong Drive ShaftLtd has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth.

Summary

Overall, we would be extremely cautious before making any decision on Xuchang Yuandong Drive ShaftLtd. The company has seen a lack of earnings growth as a result of retaining very little profits and whatever little it does retain, is being reinvested at a very low rate of return. Up till now, we've only made a short study of the company's growth data. To gain further insights into Xuchang Yuandong Drive ShaftLtd'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.