Could The Market Be Wrong About Tencent Holdings Limited (HKG:700) Given Its Attractive Financial Prospects?

With its stock down 6.7% over the past three months, it is easy to disregard Tencent Holdings (HKG:700). However, a closer look at its sound financials might cause you to think again. Given that fundamentals usually drive long-term market outcomes, the company is worth looking at. Specifically, we decided to study Tencent Holdings' 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 Tencent Holdings

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 Tencent Holdings is:

24% = CN¥197b ÷ CN¥831b (Based on the trailing twelve months to September 2023).

The 'return' is the profit over the last twelve months. That means that for every HK$1 worth of shareholders' equity, the company generated HK$0.24 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. 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. 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.

Tencent Holdings' Earnings Growth And 24% ROE

First thing first, we like that Tencent Holdings has an impressive ROE. Additionally, the company's ROE is higher compared to the industry average of 9.9% which is quite remarkable. This probably laid the groundwork for Tencent Holdings' moderate 20% net income growth seen over the past five years.

Next, on comparing with the industry net income growth, we found that Tencent Holdings' growth is quite high when compared to the industry average growth of 6.4% in the same period, which is great to see.

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. Doing so will help them establish if the stock's future looks promising or ominous. What is 700 worth today? The intrinsic value infographic in our free research report helps visualize whether 700 is currently mispriced by the market.

Is Tencent Holdings Making Efficient Use Of Its Profits?

Tencent Holdings has a low three-year median payout ratio of 7.2%, meaning that the company retains the remaining 93% of its profits. This suggests that the management is reinvesting most of the profits to grow the business.

Moreover, Tencent Holdings is determined to keep sharing its profits with shareholders which we infer from its long history of paying a dividend for at least ten years. Our latest analyst data shows that the future payout ratio of the company is expected to rise to 12% over the next three years. Accordingly, the expected increase in the payout ratio explains the expected decline in the company's ROE to 16%, over the same period.

Summary

Overall, we are quite pleased with Tencent Holdings' performance. In particular, it's great to see that the company is investing heavily into its business and along with a high rate of return, that has resulted in a sizeable growth in its earnings. Having said that, the company's earnings growth is expected to slow down, as forecasted in the current analyst estimates. 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.