Are Zhejiang Medicine Co., Ltd.'s (SHSE:600216) Mixed Financials The Reason For Its Gloomy Performance on The Stock Market?

It is hard to get excited after looking at Zhejiang Medicine's (SHSE:600216) recent performance, when its stock has declined 7.8% over the past month. It is possible that the markets have ignored the company's differing financials and decided to lean-in to the negative sentiment. Stock prices are usually driven by a company’s financial performance over the long term, and therefore we decided to pay more attention to the company's financial performance. Specifically, we decided to study Zhejiang Medicine's ROE in this article.

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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

View our latest analysis for Zhejiang Medicine

How Do You Calculate Return On Equity?

The formula for return on equity is:

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

So, based on the above formula, the ROE for Zhejiang Medicine is:

8.1% = CN¥854m ÷ CN¥11b (Based on the trailing twelve months to September 2024).

The 'return' is the profit over the last twelve months. That means that for every CN¥1 worth of shareholders' equity, the company generated CN¥0.08 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.

A Side By Side comparison of Zhejiang Medicine's Earnings Growth And 8.1% ROE

On the face of it, Zhejiang Medicine's ROE is not much to talk about. However, its ROE is similar to the industry average of 7.7%, so we won't completely dismiss the company. Having said that, Zhejiang Medicine has shown a meagre net income growth of 2.7% over the past five years. Bear in mind, the company's ROE is not very high . So this could also be one of the reasons behind the company's low growth in earnings.

As a next step, we compared Zhejiang Medicine's net income growth with the industry and were disappointed to see that the company's growth is lower than the industry average growth of 9.1% in the same period.

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

Is Zhejiang Medicine Making Efficient Use Of Its Profits?

Despite having a moderate three-year median payout ratio of 34% (implying that the company retains the remaining 66% of its income), Zhejiang Medicine's earnings growth was quite low. So there could be some other explanation in that regard. For instance, the company's business may be deteriorating.

Additionally, Zhejiang 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. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 13% over the next three years. As a result, the expected drop in Zhejiang Medicine's payout ratio explains the anticipated rise in the company's future ROE to 12%, over the same period.

Conclusion

On the whole, we feel that the performance shown by Zhejiang Medicine can be open to many interpretations. Even though it appears to be retaining most of its profits, given the low ROE, investors may not be benefitting from all that reinvestment after all. The low earnings growth suggests our theory correct. Having said that, looking at the current analyst estimates, we found that the company's earnings are expected to gain momentum. 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.