Dongguan Huali Industries Co.,Ltd's (SHSE:603038) Has Been On A Rise But Financial Prospects Look Weak: Is The Stock Overpriced?

Dongguan Huali IndustriesLtd (SHSE:603038) has had a great run on the share market with its stock up by a significant 24% 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. Particularly, we will be paying attention to Dongguan Huali IndustriesLtd's ROE today.

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.

See our latest analysis for Dongguan Huali IndustriesLtd

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 Dongguan Huali IndustriesLtd is:

1.3% = CN¥18m ÷ CN¥1.4b (Based on the trailing twelve months to June 2024).

The 'return' is the profit 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¥0.01 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. 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. 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.

Dongguan Huali IndustriesLtd's Earnings Growth And 1.3% ROE

It is hard to argue that Dongguan Huali IndustriesLtd's ROE is much good in and of itself. Even compared to the average industry ROE of 10%, the company's ROE is quite dismal. Given the circumstances, the significant decline in net income by 37% seen by Dongguan Huali IndustriesLtd over the last five years is not surprising. 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.

However, when we compared Dongguan Huali IndustriesLtd's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 7.3% in the same period. This is quite worrisome.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). 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 Dongguan Huali IndustriesLtd is trading on a high P/E or a low P/E, relative to its industry.

Is Dongguan Huali IndustriesLtd Making Efficient Use Of Its Profits?

With a high three-year median payout ratio of 56% (implying that 44% of the profits are retained), most of Dongguan Huali IndustriesLtd'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. To know the 4 risks we have identified for Dongguan Huali IndustriesLtd visit our risks dashboard for free.

In addition, Dongguan Huali IndustriesLtd has been paying dividends over a period of seven 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 Dongguan Huali IndustriesLtd. 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. To gain further insights into Dongguan Huali IndustriesLtd'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.