Weak Financial Prospects Seem To Be Dragging Down The Hong Kong and China Gas Company Limited (HKG:3) Stock

It is hard to get excited after looking at Hong Kong and China Gas' (HKG:3) recent performance, when its stock has declined 6.2% over the past three months. To decide if this trend could continue, we decided to look at its weak fundamentals as they shape the long-term market trends. Particularly, we will be paying attention to Hong Kong and China Gas' 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. Put another way, it reveals the company's success at turning shareholder investments into profits.

View our latest analysis for Hong Kong and China Gas

How Is ROE Calculated?

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 Hong Kong and China Gas is:

9.4% = HK$6.8b ÷ HK$73b (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$0.09 in profit.

What Has ROE Got To Do With Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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. Assuming everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.

Hong Kong and China Gas' Earnings Growth And 9.4% ROE

At first glance, Hong Kong and China Gas' ROE doesn't look very promising. Yet, a closer study shows that the company's ROE is similar to the industry average of 11%. Still, Hong Kong and China Gas has seen a flat net income growth over the past five years. Remember, the company's ROE is not particularly great to begin with. So that could also be one of the reasons behind the company's flat growth in earnings.

Next, on comparing with the industry net income growth, we found that the industry grew its earnings by16% in the same period.

Earnings growth is an important metric to consider when valuing a stock. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. This then helps them determine if the stock is placed for a bright or bleak future. 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 Hong Kong and China Gas is trading on a high P/E or a low P/E, relative to its industry.

Is Hong Kong and China Gas Using Its Retained Earnings Effectively?

With a high three-year median payout ratio of 61% (implying that the company keeps only 39% of its income) of its business to reinvest into its business), most of Hong Kong and China Gas' profits are being paid to shareholders, which explains the absence of growth in earnings.

Moreover, Hong Kong and China Gas 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. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 71% of its profits over the next three years. Regardless, the future ROE for Hong Kong and China Gas is predicted to rise to 13% despite there being not much change expected in its payout ratio.

Conclusion

On the whole, Hong Kong and China Gas' performance is quite a big let-down. The company has seen a lack of earnings growth as a result of retaining very little profits and whatever little it does retain, is being reinvested at a very low rate of return. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. 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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