China Communications Services (HKG:552) has had a rough three months with its share price down 8.1%. However, the company's fundamentals look pretty decent, and long-term financials are usually aligned with future market price movements. Specifically, we decided to study China Communications Services' 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. Put another way, it reveals the company's success at turning shareholder investments into profits.

Check out our latest analysis for China Communications Services

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 Communications Services is:

8.6% = CN¥3.0b ÷ CN¥35b (Based on the trailing twelve months to December 2019).

The 'return' refers to a company's earnings over the last year. Another way to think of that is that for every HK$1 worth of equity, the company was able to earn HK$0.09 in profit.

Why Is ROE Important For Earnings Growth?

So far, we've learnt that ROE is a measure of a company's profitability. 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 Communications Services' Earnings Growth And 8.6% ROE

When you first look at it, China Communications Services' ROE doesn't look that attractive. However, given that the company's ROE is similar to the average industry ROE of 10%, we may spare it some thought. Even so, China Communications Services has shown a fairly decent growth in its net income which grew at a rate of 7.3%. Given the slightly low ROE, it is likely that there could be some other aspects that are driving this growth. For instance, the company has a low payout ratio or is being managed efficiently.

We then compared China Communications Services' net income growth with the industry and we're pleased to see that the company's growth figure is higher when compared with the industry which has a growth rate of 3.5% 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. Is China Communications Services fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is China Communications Services Using Its Retained Earnings Effectively?

China Communications Services has a three-year median payout ratio of 30%, which implies that it retains the remaining 70% of its profits. This suggests that its dividend is well covered, and given the decent growth seen by the company, it looks like management is reinvesting its earnings efficiently.

Besides, China Communications Services has been paying dividends for at least ten years or more. This shows that the company is committed to sharing profits with its shareholders. Based on the latest analysts' estimates, we found that the company's future payout ratio over the next three years is expected to hold steady at 32%. Regardless, the future ROE for China Communications Services is predicted to rise to 11% despite there being not much change expected in its payout ratio.

Conclusion

In total, it does look like China Communications Services has some positive aspects to its business. Even in spite of the low rate of return, the company has posted impressive earnings growth as a result of reinvesting heavily into its business. The latest industry analyst forecasts show that the company is expected to maintain its current growth rate. 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.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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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