Declining Stock and Decent Financials: Is The Market Wrong About Huadong Medicine Co., Ltd (SZSE:000963)?

With its stock down 10% over the past month, it is easy to disregard Huadong Medicine (SZSE:000963). However, the company's fundamentals look pretty decent, and long-term financials are usually aligned with future market price movements. In this article, we decided to focus on Huadong Medicine's ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Put another way, it reveals the company's success at turning shareholder investments into profits.

Check out our latest analysis for Huadong Medicine

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 Huadong Medicine is:

13% = CN¥2.9b ÷ CN¥22b (Based on the trailing twelve months to March 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¥0.13 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. 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 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.

Huadong Medicine's Earnings Growth And 13% ROE

At first glance, Huadong Medicine seems to have a decent ROE. Especially when compared to the industry average of 6.4% the company's ROE looks pretty impressive. Given the circumstances, we can't help but wonder why Huadong Medicine saw little to no growth in the past five years. Therefore, there could be some other aspects that could potentially be preventing the company from growing. These include low earnings retention or poor allocation of capital.

We then compared Huadong Medicine's net income growth with the industry and found that the average industry growth rate was 4.2% in the same 5-year period.

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

Is Huadong Medicine Using Its Retained Earnings Effectively?

Huadong Medicine's low three-year median payout ratio of 20%, (meaning the company retains80% of profits) should mean that the company is retaining most of its earnings and consequently, should see higher growth than it has reported.

Additionally, Huadong Medicine 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. Based on the latest analysts' estimates, we found that the company's future payout ratio over the next three years is expected to hold steady at 23%. Still, forecasts suggest that Huadong Medicine's future ROE will rise to 16% even though the the company's payout ratio is not expected to change by much.

Summary

In total, it does look like Huadong Medicine has some positive aspects to its business. However, given the high ROE and high profit retention, we would expect the company to be delivering strong earnings growth, but that isn't the case here. This suggests that there might be some external threat to the business, that's hampering its growth. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page for the company.

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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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com