Hangzhou Zhongheng Electric Co., Ltd's (SZSE:002364) On An Uptrend But Financial Prospects Look Pretty Weak: Is The Stock Overpriced?

Hangzhou Zhongheng Electric (SZSE:002364) has had a great run on the share market with its stock up by a significant 65% over the last 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. Specifically, we decided to study Hangzhou Zhongheng Electric's ROE in this article.

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 short, ROE shows the profit each dollar generates with respect to its shareholder investments.

Check out our latest analysis for Hangzhou Zhongheng Electric

How Do You 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 Hangzhou Zhongheng Electric is:

3.9% = CN¥93m ÷ CN¥2.4b (Based on the trailing twelve months to September 2024).

The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each CN¥1 of shareholders' capital it has, the company made CN¥0.04 in profit.

What Is The Relationship Between ROE And Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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.

A Side By Side comparison of Hangzhou Zhongheng Electric's Earnings Growth And 3.9% ROE

It is hard to argue that Hangzhou Zhongheng Electric's ROE is much good in and of itself. Even compared to the average industry ROE of 6.5%, the company's ROE is quite dismal. Therefore, it might not be wrong to say that the five year net income decline of 18% seen by Hangzhou Zhongheng Electric was possibly a result of it having a lower ROE. We reckon that there could also be other factors at play here. 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 Hangzhou Zhongheng 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 10% over the last few years.

Earnings growth is an important metric to consider when valuing a stock. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. 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 Hangzhou Zhongheng Electric is trading on a high P/E or a low P/E, relative to its industry.

Is Hangzhou Zhongheng Electric Efficiently Re-investing Its Profits?

Hangzhou Zhongheng Electric has a high three-year median payout ratio of 71% (that is, it is retaining 29% of its profits). This suggests that the company is paying most of its profits as dividends to its shareholders. This goes some way in explaining why its earnings have been shrinking. The business is only left with a small pool of capital to reinvest - A vicious cycle that doesn't benefit the company in the long-run. To know the 3 risks we have identified for Hangzhou Zhongheng Electric visit our risks dashboard for free.

Additionally, Hangzhou Zhongheng Electric has paid dividends over a period of at least ten years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth.

Conclusion

Overall, we would be extremely cautious before making any decision on Hangzhou Zhongheng Electric. 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. So far, we've only made a quick discussion around the company's earnings growth. To gain further insights into Hangzhou Zhongheng 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.