Most readers will already know that shares of Design Capital (HKG:1545) are up a significant 27% over the past month. Given the company’s impressive performance, we decided to take a closer look at its financial metrics, as a company’s long-term financial health usually dictates market outcomes. In particular, we’ll be paying close attention to Design Capital’s ROE today.
Return on equity or ROE is a key metric used to gauge how effectively a company’s management is using the company’s capital. In other words, it reveals the company’s success in turning shareholders’ investments into profits.
Check out our latest analysis for Design Capital
How is ROE calculated?
the ROE formula is:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, the ROE for Design Capital is:
11% = $5.9 million ÷ $55 million (based on trailing 12 months to December 2021).
The “yield” is the profit of the last twelve months. This therefore means that for each investment of 1 HK$ invested by its shareholder, the company generates a profit of 0.11 HK$.
What is the relationship between ROE and earnings growth?
We have already established that ROE serves as an effective profit-generating indicator for a company’s future earnings. Depending on how much of those earnings the company reinvests or “keeps”, and how efficiently it does so, we are then able to gauge a company’s earnings growth potential. Assuming everything else remains unchanged, the higher the ROE and earnings retention, the higher a company’s growth rate compared to companies that don’t necessarily exhibit these characteristics.
Design Capital earnings growth and 11% ROE
For starters, Design Capital seems to have a respectable ROE. Compared to the industry average ROE of 5.8%, the company’s ROE looks quite remarkable. However, for some reason, the higher returns are not reflected in Design Capital’s low average five-year net income growth of 3.5%. This is usually not the case because when a company has a high rate of return, it should generally also have a high rate of earnings growth. A few likely reasons why this could happen are that the company might have a high payout ratio or the company has misallocated capital, for example.
Considering the fact that industry profits fell 0.7% over the same period, the company’s net profit growth is quite remarkable.
Earnings growth is an important metric to consider when evaluating a stock. The investor should try to establish whether the expected growth or decline in earnings, as the case may be, is taken into account. This will help him determine if the future of the stock looks bright or ominous. If you’re wondering about Design Capital’s valuation, check out this indicator of its price-earnings ratio, relative to its sector.
Is Design Capital effectively using its retained earnings?
The high three-year median payout ratio of 59% (i.e. the company retains only 41% of its revenue) over the past three years for Design Capital suggests that the company’s earnings growth company was weaker due to the payment of the majority of its earnings.
Also, Design Capital only recently started paying a dividend, so management had to decide that shareholders preferred dividends to earnings growth.
Overall, we are quite satisfied with Design Capital’s performance. We are particularly impressed with the company’s tremendous earnings growth, which was likely supported by its strong ROE. Although the company pays most of its profits in the form of dividends, it was able to increase its profits despite this, so this is probably a good sign. If the company continues to increase its earnings as it has, it could have a positive impact on its share price given how earnings per share influence prices over the long term. Remember that the price of a stock also depends on the perceived risk. Therefore, investors should be aware of the risks involved before investing in a company. To learn about the 4 risks we have identified for Design Capital, visit our risk dashboard for free.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.