China Leon Inspection Holding Limited's (HKG:1586) Stock Is Going Strong: Have Financials A Role To Play?

China Leon Inspection Holding (HKG:1586) has had a great run on the share market with its stock up by a significant 8.8% over the last week. Given that stock prices are usually aligned with a company's financial performance in the long-term, we decided to study its financial indicators more closely to see if they had a hand to play in the recent price move. Specifically, we decided to study China Leon Inspection Holding'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 other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

Check out our latest analysis for China Leon Inspection Holding

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 China Leon Inspection Holding is:

19% = CN¥48m ÷ CN¥250m (Based on the trailing twelve months to June 2020).

The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each HK$1 of shareholders' capital it has, the company made HK$0.19 in profit.

What Has ROE Got To Do With 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. 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 China Leon Inspection Holding's Earnings Growth And 19% ROE

At first glance, China Leon Inspection Holding seems to have a decent ROE. Further, the company's ROE compares quite favorably to the industry average of 5.8%. As you might expect, the 6.3% net income decline reported by China Leon Inspection Holding is a bit of a surprise. We reckon that there could be some other factors at play here that are preventing the company's growth. For example, it could be that the company has a high payout ratio or the business has allocated capital poorly, for instance.

However, when we compared China Leon Inspection Holding's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 29% in the same period. This is quite worrisome.

Earnings growth is a huge factor in stock valuation. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. 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 China Leon Inspection Holding is trading on a high P/E or a low P/E, relative to its industry.

Is China Leon Inspection Holding Making Efficient Use Of Its Profits?

In spite of a normal three-year median payout ratio of 28% (that is, a retention ratio of 72%), the fact that China Leon Inspection Holding's earnings have shrunk is quite puzzling. It looks like there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.

Moreover, China Leon Inspection Holding has been paying dividends for four years, which is a considerable amount of time, suggesting that management must have perceived that the shareholders prefer consistent dividends even though earnings have been shrinking.

Conclusion

In total, it does look like China Leon Inspection Holding has some positive aspects to its business. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE and and a high reinvestment rate. We believe that there might be some outside factors that could be having a negative impact on the business. While we won't completely dismiss the company, what we would do, is try to ascertain how risky the business is to make a more informed decision around the company. To know the 3 risks we have identified for China Leon Inspection Holding visit our risks dashboard for free.

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This article by Simply Wall St is general in nature. 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.
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