With its stock down 3.1% over the past month, it is easy to disregard China Leon Inspection Holding (HKG:1586). But if you pay close attention, you might find that its key financial indicators look quite decent, which could mean that the stock could potentially rise in the long-term given how markets usually reward more resilient long-term fundamentals. In this article, we decided to focus on China Leon Inspection Holding'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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
How Is ROE Calculated?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for China Leon Inspection Holding is:
13% = CN¥29m ÷ CN¥221m (Based on the trailing twelve months to December 2019).
The 'return' is the yearly profit. Another way to think of that is that for every HK$1 worth of equity, the company was able to earn HK$0.13 in profit.
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. 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. 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.
China Leon Inspection Holding's Earnings Growth And 13% ROE
At first glance, China Leon Inspection Holding seems to have a decent ROE. Especially when compared to the industry average of 8.8% the company's ROE looks pretty impressive. As you might expect, the 11% net income decline reported by China Leon Inspection Holding is a bit of a surprise. Therefore, there might be some other aspects that could explain this. For example, it could be that the company has a high payout ratio or the business has allocated capital poorly, for instance.
That being said, we compared China Leon Inspection Holding's performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 8.0% 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. 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 Leon Inspection Holding is trading on a high P/E or a low P/E, relative to its industry.
Is China Leon Inspection Holding Making Efficient Use Of Its Profits?
When we piece together China Leon Inspection Holding's low three-year median payout ratio of 24% (where it is retaining 76% of its profits), calculated for the last three-year period, we are puzzled by the lack of growth. The low payout should mean that the company is retaining most of its earnings and consequently, should see some growth. So there could be some other explanations in that regard. For example, the company's business may be deteriorating.
In addition, China Leon Inspection Holding has been paying dividends over a period of three years suggesting that keeping up dividend payments is preferred by the management even though earnings have been in decline.
Overall, we feel that China Leon Inspection Holding certainly does have some positive factors to consider. However, given the high ROE and high profit retention, we would expect the company to be delivering strong earnings growth, but that isn't the case here. This suggests that there might be some external threat to the business, that's hampering its growth. While we won't completely dismiss the company, what we would do, is try to ascertain how risky the business is to make a more informed decision around the company. Our risks dashboard would have the 3 risks we have identified for China Leon Inspection Holding.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned.
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