Are China Tobacco International (HK) Company Limited's (HKG:6055) Fundamentals Good Enough to Warrant Buying Given The Stock's Recent Weakness?

With its stock down 3.0% over the past three months, it is easy to disregard China Tobacco International (HK) (HKG:6055). However, the company's fundamentals look pretty decent, and long-term financials are usually aligned with future market price movements. In this article, we decided to focus on China Tobacco International (HK)'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. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

View our latest analysis for China Tobacco International (HK)

How To 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 Tobacco International (HK) is:

16% = HK$246m ÷ HK$1.5b (Based on the trailing twelve months to June 2020).

The 'return' is the amount earned after tax over the last twelve months. Another way to think of that is that for every HK$1 worth of equity, the company was able to earn HK$0.16 in profit.

What Has ROE Got To Do With 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.

China Tobacco International (HK)'s Earnings Growth And 16% ROE

To start with, China Tobacco International (HK)'s ROE looks acceptable. On comparing with the average industry ROE of 4.4% the company's ROE looks pretty remarkable. Needless to say, we are quite surprised to see that China Tobacco International (HK)'s net income shrunk at a rate of 10.0% over the past five years. Therefore, there might be some other aspects that could explain this. Such as, the company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.

So, as a next step, we compared China Tobacco International (HK)'s performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 13% in the same period.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. 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 Tobacco International (HK) is trading on a high P/E or a low P/E, relative to its industry.

Is China Tobacco International (HK) Using Its Retained Earnings Effectively?

In spite of a normal three-year median payout ratio of 37% (that is, a retention ratio of 63%), the fact that China Tobacco International (HK)'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.

In addition, China Tobacco International (HK) only recently started paying a dividend so the management probably decided the shareholders prefer dividends even though earnings have been shrinking.

Conclusion

On the whole, we do feel that China Tobacco International (HK) has some positive attributes. 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. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.

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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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