Zhongyeda Electric Co., Ltd.'s (SZSE:002441) Stock's Been Going Strong: Could Weak Financials Mean The Market Will Correct Its Share Price?

Most readers would already be aware that Zhongyeda Electric's (SZSE:002441) stock increased significantly by 15% over the past three months. However, in this article, we decided to focus on its weak fundamentals, as long-term financial performance of a business is what ultimately dictates market outcomes. In this article, we decided to focus on Zhongyeda Electric's ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

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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 Zhongyeda Electric is:

3.0% = CN¥137m ÷ CN¥4.6b (Based on the trailing twelve months to September 2024).

The 'return' refers to a company's earnings over the last year. So, this means that for every CN¥1 of its shareholder's investments, the company generates a profit of CN¥0.03.

See our latest analysis for Zhongyeda Electric

What Has ROE Got To Do With Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. 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.

Zhongyeda Electric's Earnings Growth And 3.0% ROE

It is hard to argue that Zhongyeda Electric's ROE is much good in and of itself. Even compared to the average industry ROE of 6.6%, the company's ROE is quite dismal. For this reason, Zhongyeda Electric's five year net income decline of 2.4% is not surprising given its lower ROE. We reckon that there could also be other factors at play here. Such as - low earnings retention or poor allocation of capital.

However, when we compared Zhongyeda Electric's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 7.0% in the same period. This is quite worrisome.

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. 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 Zhongyeda Electric is trading on a high P/E or a low P/E, relative to its industry.

Is Zhongyeda Electric Making Efficient Use Of Its Profits?

With a high three-year median payout ratio of 64% (implying that 36% of the profits are retained), most of Zhongyeda Electric's profits are being paid to shareholders, which explains the company's shrinking earnings. With only a little being reinvested into the business, earnings growth would obviously be low or non-existent. Our risks dashboard should have the 3 risks we have identified for Zhongyeda Electric.

Moreover, Zhongyeda Electric has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over earnings growth.

Conclusion

Overall, we would be extremely cautious before making any decision on Zhongyeda 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. Until now, we have only just grazed the surface of the company's past performance by looking at the company's fundamentals. You can do your own research on Zhongyeda Electric and see how it has performed in the past by looking at this FREE detailed graph 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.