Declining Stock and Decent Financials: Is The Market Wrong About China Shengmu Organic Milk Limited (HKG:1432)?

It is hard to get excited after looking at China Shengmu Organic Milk's (HKG:1432) recent performance, when its stock has declined 20% over the past three months. However, stock prices are usually driven by a company’s financials over the long term, which in this case look pretty respectable. Specifically, we decided to study China Shengmu Organic Milk'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. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

See our latest analysis for China Shengmu Organic Milk

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 China Shengmu Organic Milk is:

12% = CN¥322m ÷ CN¥2.7b (Based on the trailing twelve months to June 2020).

The 'return' is the yearly profit. One way to conceptualize this is that for each HK$1 of shareholders' capital it has, the company made HK$0.12 in profit.

What Is The Relationship Between ROE And Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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. 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.

A Side By Side comparison of China Shengmu Organic Milk's Earnings Growth And 12% ROE

At first glance, China Shengmu Organic Milk seems to have a decent ROE. Further, the company's ROE is similar to the industry average of 11%. As you might expect, the 49% net income decline reported by China Shengmu Organic Milk 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. Such as, the company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.

That being said, we compared China Shengmu Organic Milk's performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 11% in the same period.

Earnings growth is a huge factor in stock valuation. 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. If you're wondering about China Shengmu Organic Milk's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is China Shengmu Organic Milk Efficiently Re-investing Its Profits?

Conclusion

In total, it does look like China Shengmu Organic Milk 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. 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 4 risks we have identified for China Shengmu Organic Milk 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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