Aarey Drugs & Pharmaceuticals Limited's (NSE:AAREYDRUGS) Stock Is Rallying But Financials Look Ambiguous: Will The Momentum Continue?

Most readers would already be aware that Aarey Drugs & Pharmaceuticals' (NSE:AAREYDRUGS) stock increased significantly by 20% over the past three months. However, we decided to pay attention to the company's fundamentals which don't appear to give a clear sign about the company's financial health. Particularly, we will be paying attention to Aarey Drugs & Pharmaceuticals' ROE today.

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

Check out our latest analysis for Aarey Drugs & Pharmaceuticals

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 Aarey Drugs & Pharmaceuticals is:

3.9% = ₹52m ÷ ₹1.3b (Based on the trailing twelve months to June 2024).

The 'return' is the yearly profit. So, this means that for every ₹1 of its shareholder's investments, the company generates a profit of ₹0.04.

What Has ROE Got To Do With Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. 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.

Aarey Drugs & Pharmaceuticals' Earnings Growth And 3.9% ROE

As you can see, Aarey Drugs & Pharmaceuticals' ROE looks pretty weak. Even compared to the average industry ROE of 12%, the company's ROE is quite dismal. Therefore, it might not be wrong to say that the five year net income decline of 11% seen by Aarey Drugs & Pharmaceuticals was possibly a result of it having a lower ROE. We believe that there also might be other aspects that are negatively influencing the company's earnings prospects. For example, the business has allocated capital poorly, or that the company has a very high payout ratio.

So, as a next step, we compared Aarey Drugs & Pharmaceuticals' 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 15% over the last few years.

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. This then helps them determine if the stock is placed for a bright or bleak future. Is Aarey Drugs & Pharmaceuticals fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Aarey Drugs & Pharmaceuticals Using Its Retained Earnings Effectively?

Aarey Drugs & Pharmaceuticals doesn't pay any regular dividends, meaning that the company is keeping all of its profits, which makes us wonder why it is retaining its earnings if it can't use them to grow its business. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.

Conclusion

Overall, we have mixed feelings about Aarey Drugs & Pharmaceuticals. Even though it appears to be retaining most of its profits, given the low ROE, investors may not be benefitting from all that reinvestment after all. The low earnings growth suggests our theory correct. Wrapping up, we would proceed with caution with this company and one way of doing that would be to look at the risk profile of the business. Our risks dashboard would have the 3 risks we have identified for Aarey Drugs & Pharmaceuticals.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.