Asahi Songwon Colors Limited (NSE:ASAHISONG) Is Going Strong But Fundamentals Appear To Be Mixed : Is There A Clear Direction For The Stock?

Asahi Songwon Colors' (NSE:ASAHISONG) stock is up by a considerable 17% over the past three months. However, we decided to pay attention to the company's fundamentals which don't appear to give a clear sign about the company's financial health. Specifically, we decided to study Asahi Songwon Colors' ROE in this article.

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 Asahi Songwon Colors

How Is ROE Calculated?

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 Asahi Songwon Colors is:

10% = ₹269m ÷ ₹2.7b (Based on the trailing twelve months to September 2020).

The 'return' is the profit over the last twelve months. That means that for every ₹1 worth of shareholders' equity, the company generated ₹0.10 in profit.

Why Is ROE Important For 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. 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 Asahi Songwon Colors' Earnings Growth And 10% ROE

On the face of it, Asahi Songwon Colors' ROE is not much to talk about. Yet, a closer study shows that the company's ROE is similar to the industry average of 11%. We can see that Asahi Songwon Colors has grown at a five year net income growth average rate of 2.1%, which is a bit on the lower side. Remember, the company's ROE is not particularly great to begin with. So this could also be one of the reasons behind the company's low growth in earnings.

Next, on comparing with the industry net income growth, we found that Asahi Songwon Colors' reported growth was lower than the industry growth of 15% in the same period, which is not something we like to see.

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. 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 Asahi Songwon Colors is trading on a high P/E or a low P/E, relative to its industry.

Is Asahi Songwon Colors Making Efficient Use Of Its Profits?

Asahi Songwon Colors' low three-year median payout ratio of 16% (or a retention ratio of 84%) should mean that the company is retaining most of its earnings to fuel its growth. This should be reflected in its earnings growth number, but that's not the case. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.

Additionally, Asahi Songwon Colors has paid dividends over a period of at least ten years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth.

Conclusion

On the whole, we feel that the performance shown by Asahi Songwon Colors can be open to many interpretations. Even though it appears to be retaining most of its profits, given the low ROE, investors may not be benefitting from all that reinvestment after all. The low earnings growth suggests our theory correct. Wrapping up, we would proceed with caution with this company and one way of doing that would be to look at the risk profile of the business. Our risks dashboard would have the 2 risks we have identified for Asahi Songwon Colors.

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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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