Most readers would already be aware that Yum China Holdings' (NYSE:YUMC) stock increased significantly by 15% over the past month. Given that the market rewards strong financials in the long-term, we wonder if that is the case in this instance. In this article, we decided to focus on Yum China Holdings' ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

See our latest analysis for Yum China Holdings

How Is ROE Calculated?

The formula for ROE is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Yum China Holdings is:

15% = US$990m ÷ US$6.6b (Based on the trailing twelve months to March 2021).

The 'return' is the yearly profit. That means that for every $1 worth of shareholders' equity, the company generated $0.15 in profit.

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. 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.

Yum China Holdings' Earnings Growth And 15% ROE

To start with, Yum China Holdings' ROE looks acceptable. Especially when compared to the industry average of 11% the company's ROE looks pretty impressive. Probably as a result of this, Yum China Holdings was able to see a decent growth of 14% over the last five years.

Next, on comparing with the industry net income growth, we found that the growth figure reported by Yum China Holdings compares quite favourably to the industry average, which shows a decline of 5.8% 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. 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 Yum China Holdings is trading on a high P/E or a low P/E, relative to its industry.

Is Yum China Holdings Efficiently Re-investing Its Profits?

Yum China Holdings has a healthy combination of a moderate three-year median payout ratio of 25% (or a retention ratio of 75%) and a respectable amount of growth in earnings as we saw above, meaning that the company has been making efficient use of its profits.

Besides, Yum China Holdings has been paying dividends over a period of four years. 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 24%. Accordingly, forecasts suggest that Yum China Holdings' future ROE will be 15% which is again, similar to the current ROE.

Conclusion

On the whole, we feel that Yum China Holdings' performance has been quite good. Specifically, we like that the company is reinvesting a huge chunk of its profits at a high rate of return. This of course has caused the company to see substantial growth in its earnings. On studying current analyst estimates, we found that analysts expect the company to continue its recent growth streak. 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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