With its stock down 13% over the past three months, it is easy to disregard China Tobacco International (HK) (HKG:6055). 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 Tobacco International (HK)'s ROE in this article.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

View our latest analysis for China Tobacco International (HK)

How Do You Calculate Return On Equity?

ROE 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 Tobacco International (HK) is:

20% = HK$319m ÷ HK$1.6b (Based on the trailing twelve months to December 2019).

The 'return' refers to a company's earnings over the last year. That means that for every HK$1 worth of shareholders' equity, the company generated HK$0.20 in profit.

What Has ROE Got To Do With Earnings Growth?

Thus far, we have learnt that ROE measures how efficiently a company is generating its profits. 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. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don’t share these attributes.

China Tobacco International (HK)'s Earnings Growth And 20% ROE

To begin with, China Tobacco International (HK) seems to have a respectable ROE. Further, the company's ROE compares quite favorably to the industry average of 8.5%. For this reason, China Tobacco International (HK)'s five year net income decline of 11% raises the question as to why the high ROE didn't translate into earnings growth. 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.

So, as a next step, we compared China Tobacco International (HK)'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 2.4% in the same period.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. 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 Tobacco International (HK) is trading on a high P/E or a low P/E, relative to its industry.