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Should Weakness in Fanhua Inc.'s (NASDAQ:FANH) Stock Be Seen As A Sign That Market Will Correct The Share Price Given Decent Financials?

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With its stock down 12% over the past three months, it is easy to disregard Fanhua (NASDAQ:FANH). 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 Fanhua's 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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

View our latest analysis for Fanhua

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 Fanhua is:

14% = CN¥276m ÷ CN¥2.0b (Based on the trailing twelve months to December 2020).

The 'return' is the yearly profit. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.14.

What Has ROE Got To Do With Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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. 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.

Fanhua's Earnings Growth And 14% ROE

To begin with, Fanhua seems to have a respectable ROE. Especially when compared to the industry average of 9.6% the company's ROE looks pretty impressive. Yet, Fanhua has posted measly growth of 4.2% over the past five years. This is interesting as the high returns should mean that the company has the ability to generate high growth but for some reason, it hasn't been able to do so. A few likely reasons why this could happen is that the company could have a high payout ratio or the business has allocated capital poorly, for instance.

As a next step, we compared Fanhua's net income growth with the industry and were disappointed to see that the company's growth is lower than the industry average growth of 9.5% in the same period.

past-earnings-growth
past-earnings-growth

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 Fanhua is trading on a high P/E or a low P/E, relative to its industry.

Is Fanhua Making Efficient Use Of Its Profits?

The high three-year median payout ratio of 75% (that is, the company retains only 25% of its income) over the past three years for Fanhua suggests that the company's earnings growth was lower as a result of paying out a majority of its earnings.

Additionally, Fanhua has paid dividends over a period of at least ten years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 60% over the next three years. The fact that the company's ROE is expected to rise to 25% over the same period is explained by the drop in the payout ratio.

Conclusion

On the whole, we do feel that Fanhua has some positive attributes. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE. Bear in mind, the company reinvests a small portion of its profits, which means that investors aren't reaping the benefits of the high rate of return. That being so, the latest analyst forecasts show that the company will continue to see an expansion in its earnings. 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.

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. 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.

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