With its stock down 13% over the past three months, it is easy to disregard Aarti Drugs (NSE:AARTIDRUGS). However, stock prices are usually driven by a company’s financial performance over the long term, which in this case looks quite promising. Specifically, we decided to study Aarti Drugs' 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. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
How To Calculate Return On Equity?
Return on equity 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 Aarti Drugs is:
30% = ₹2.5b ÷ ₹8.1b (Based on the trailing twelve months to September 2020).
The 'return' is the yearly profit. Another way to think of that is that for every ₹1 worth of equity, the company was able to earn ₹0.30 in profit.
Why Is ROE Important For Earnings Growth?
We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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 all else is equal, companies that have both a higher return on equity and higher profit retention are usually the ones that have a higher growth rate when compared to companies that don't have the same features.
A Side By Side comparison of Aarti Drugs' Earnings Growth And 30% ROE
Firstly, we acknowledge that Aarti Drugs has a significantly high ROE. Second, a comparison with the average ROE reported by the industry of 14% also doesn't go unnoticed by us. As a result, Aarti Drugs' exceptional 22% net income growth seen over the past five years, doesn't come as a surprise.
Next, on comparing with the industry net income growth, we found that Aarti Drugs' growth is quite high when compared to the industry average growth of 16% in the same period, which is great to see.
Earnings growth is an important metric to consider when valuing a stock. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). 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 Aarti Drugs is trading on a high P/E or a low P/E, relative to its industry.
Is Aarti Drugs Using Its Retained Earnings Effectively?
Aarti Drugs has a really low three-year median payout ratio of 3.1%, meaning that it has the remaining 97% left over to reinvest into its business. So it seems like the management is reinvesting profits heavily to grow its business and this reflects in its earnings growth number.
Additionally, Aarti Drugs has paid dividends over a period of at least ten years which means that the company is pretty serious about sharing its profits with shareholders. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to rise to 14% over the next three years. Regardless, the ROE is not expected to change much for the company despite the higher expected payout ratio.
In total, we are pretty happy with Aarti Drugs' performance. In particular, it's great to see that the company is investing heavily into its business and along with a high rate of return, that has resulted in a sizeable growth in its earnings. That being so, a study of the latest analyst forecasts show that the company is expected to see a slowdown in its future earnings growth. 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.
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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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