China Steel Corporation's (TWSE:2002) Stock Going Strong But Fundamentals Look Weak: What Implications Could This Have On The Stock?

China Steel (TWSE:2002) has had a great run on the share market with its stock up by a significant 12% over the last month. We, however wanted to have a closer look at its key financial indicators as the markets usually pay for long-term fundamentals, and in this case, they don't look very promising. Particularly, we will be paying attention to China Steel's ROE today.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

See our latest analysis for China Steel

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 China Steel is:

1.4% = NT$4.9b ÷ NT$343b (Based on the trailing twelve months to June 2024).

The 'return' is the yearly profit. One way to conceptualize this is that for each NT$1 of shareholders' capital it has, the company made NT$0.01 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. 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. 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.

A Side By Side comparison of China Steel's Earnings Growth And 1.4% ROE

It is quite clear that China Steel's ROE is rather low. Even compared to the average industry ROE of 7.2%, the company's ROE is quite dismal. For this reason, China Steel's five year net income decline of 3.3% is not surprising given its lower ROE. We believe that there also might be other aspects that are negatively influencing the company's earnings prospects. For instance, the company has a very high payout ratio, or is faced with competitive pressures.

So, as a next step, we compared China Steel'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 17% over the last few years.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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. If you're wondering about China Steel's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is China Steel Making Efficient Use Of Its Profits?

China Steel's declining earnings is not surprising given how the company is spending most of its profits in paying dividends, judging by its three-year median payout ratio of 82% (or a retention ratio of 18%). With only a little being reinvested into the business, earnings growth would obviously be low or non-existent.

In addition, China Steel has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 65% over the next three years. As a result, the expected drop in China Steel's payout ratio explains the anticipated rise in the company's future ROE to 2.9%, over the same period.

Summary

Overall, we would be extremely cautious before making any decision on China Steel. 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. 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. 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.