Declining Stock and Decent Financials: Is The Market Wrong About China Traditional Chinese Medicine Holdings Co. Limited (HKG:570)?

China Traditional Chinese Medicine Holdings (HKG:570) has had a rough three months with its share price down 5.7%. However, stock prices are usually driven by a company’s financials over the long term, which in this case look pretty respectable. Particularly, we will be paying attention to China Traditional Chinese Medicine Holdings' ROE today.

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 China Traditional Chinese Medicine Holdings

How Do You Calculate Return On Equity?

Return on equity 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 China Traditional Chinese Medicine Holdings is:

8.4% = CN¥1.6b ÷ CN¥20b (Based on the trailing twelve months to June 2020).

The 'return' refers to a company's earnings over the last year. So, this means that for every HK$1 of its shareholder's investments, the company generates a profit of HK$0.08.

What Is The Relationship Between ROE And Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. 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.

China Traditional Chinese Medicine Holdings' Earnings Growth And 8.4% ROE

When you first look at it, China Traditional Chinese Medicine Holdings' ROE doesn't look that attractive. However, its ROE is similar to the industry average of 10%, so we won't completely dismiss the company. Moreover, we are quite pleased to see that China Traditional Chinese Medicine Holdings' net income grew significantly at a rate of 21% over the last five years. Considering the moderately low ROE, it is quite possible that there might be some other aspects that are positively influencing the company's earnings growth. Such as - high earnings retention or an efficient management in place.

We then compared China Traditional Chinese Medicine Holdings' net income growth with the industry and we're pleased to see that the company's growth figure is higher when compared with the industry which has a growth rate of 16% in the same period.

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. Doing so will help them establish if the stock's future looks promising or ominous. Has the market priced in the future outlook for 570? You can find out in our latest intrinsic value infographic research report.

Is China Traditional Chinese Medicine Holdings Using Its Retained Earnings Effectively?

While the company did pay out a portion of its dividend in the past, it currently doesn't pay a dividend. This is likely what's driving the high earnings growth number discussed above.

Based on the latest analysts' estimates, we found that the company's future payout ratio over the next three years is expected to hold steady at 29%. Therefore, the company's future ROE is also not expected to change by much with analysts predicting an ROE of 9.8%.

Conclusion

On the whole, we do feel that China Traditional Chinese Medicine Holdings has some positive attributes. Despite its low rate of return, the fact that the company reinvests a very high portion of its profits into its business, no doubt contributed to its high earnings growth. With that said, the latest industry analyst forecasts reveal that the company's earnings growth is expected to slow down. 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. 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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