Most readers would already know that Churchill China’s (LON:CHH) stock increased by 3.6% over the past week. Given that stock prices are usually aligned with a company’s financial performance in the long-term, we decided to investigate if the company’s decent financials had a hand to play in the recent price move. In this article, we decided to focus on Churchill China’s ROE.
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. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
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 Churchill China is:
9.8% = UK£4.2m ÷ UK£43m (Based on the trailing twelve months to December 2021).
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?
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.
A Side By Side comparison of Churchill China’s Earnings Growth And 9.8% ROE
To begin with, Churchill China seems to have a respectable ROE. Further, the company’s ROE is similar to the industry average of 11%. For this reason, Churchill China’s five year net income decline of 17% raises the question as to why the decent ROE didn’t translate into growth. We reckon that there could be some other factors at play here that are preventing the company’s growth. For example, it could be that the company has a high payout ratio or the business has allocated capital poorly, for instance.
Next, when we compared with the industry, which has shrunk its earnings at a rate of 7.8% in the same period, we still found Churchill China’s performance to be quite bleak, because the company has been shrinking its earnings faster than the industry.
Earnings growth is a huge factor in stock valuation. 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. 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 Churchill China is trading on a high P/E or a low P/E, relative to its industry.
Is Churchill China Efficiently Re-investing Its Profits?
In spite of a normal three-year median payout ratio of 34% (that is, a retention ratio of 66%), the fact that Churchill China’s earnings have shrunk is quite puzzling. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.
In addition, Churchill China 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. Upon studying the latest analysts’ consensus data, we found that the company’s future payout ratio is expected to rise to 50% over the next three years. Still, forecasts suggest that Churchill China’s future ROE will rise to 16% even though the the company’s payout ratio is expected to rise. We presume that there could some other characteristics of the business that could be driving the anticipated growth in the company’s ROE.
In total, it does look like Churchill China has some positive aspects to its business. 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. 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. 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.