Should Weakness in Hengan International Group Company Limited's (HKG:1044) Stock Be Seen As A Sign That Market Will Correct The Share Price Given Decent Financials?

It is hard to get excited after looking at Hengan International Group's (HKG:1044) recent performance, when its stock has declined 6.2% 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. In this article, we decided to focus on Hengan International Group's ROE.

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

See our latest analysis for Hengan International Group

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 Hengan International Group is:

14% = CN¥3.0b ÷ CN¥21b (Based on the trailing twelve months to June 2024).

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$0.14 in profit.

Why Is ROE Important For 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 all else is equal, companies that have both a higher return on equity and higher profit retention are usually the ones that have a higher growth rate when compared to companies that don't have the same features.

A Side By Side comparison of Hengan International Group's Earnings Growth And 14% ROE

To start with, Hengan International Group's ROE looks acceptable. On comparing with the average industry ROE of 9.9% the company's ROE looks pretty remarkable. For this reason, Hengan International Group's five year net income decline of 13% raises the question as to why the high ROE didn't translate into earnings growth. Based on this, we feel that there might be other reasons which haven't been discussed so far in this article that could be hampering the company's growth. Such as, the company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.

However, when we compared Hengan International Group's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 1.5% in the same period. This is quite worrisome.

Earnings growth is an important metric to consider when valuing a stock. 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. What is 1044 worth today? The intrinsic value infographic in our free research report helps visualize whether 1044 is currently mispriced by the market.

Is Hengan International Group Using Its Retained Earnings Effectively?

Hengan International Group's declining earnings is not surprising given how the company is spending most of its profits in paying dividends, judging by its three-year median payout ratio of 63% (or a retention ratio of 37%). The business is only left with a small pool of capital to reinvest - A vicious cycle that doesn't benefit the company in the long-run.

Moreover, Hengan International Group has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over earnings growth. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 54%. Therefore, the company's future ROE is also not expected to change by much with analysts predicting an ROE of 12%.

Conclusion

In total, it does look like Hengan International Group has some positive aspects to its business. However, while the company does have a high ROE, its earnings growth number is quite disappointing. This can be blamed on the fact that it reinvests only a small portion of its profits and pays out the rest as dividends. That being so, the latest industry analyst forecasts show that the analysts are expecting to see a huge improvement in the company's earnings growth rate. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts 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.