Are Aarti Pharmalabs Limited's (NSE:AARTIPHARM) Fundamentals Good Enough to Warrant Buying Given The Stock's Recent Weakness?

With its stock down 10% over the past three months, it is easy to disregard Aarti Pharmalabs (NSE:AARTIPHARM). However, stock prices are usually driven by a company’s financials over the long term, which in this case look pretty respectable. Specifically, we decided to study Aarti Pharmalabs' ROE in this article.

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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

Check out our latest analysis for Aarti Pharmalabs

How To Calculate Return On Equity?

The formula for ROE is:

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

So, based on the above formula, the ROE for Aarti Pharmalabs is:

12% = ₹2.3b ÷ ₹19b (Based on the trailing twelve months to September 2024).

The 'return' is the profit over the last twelve months. One way to conceptualize this is that for each ₹1 of shareholders' capital it has, the company made ₹0.12 in profit.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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.

A Side By Side comparison of Aarti Pharmalabs' Earnings Growth And 12% ROE

At first glance, Aarti Pharmalabs' ROE doesn't look very promising. Yet, a closer study shows that the company's ROE is similar to the industry average of 12%. Particularly, the exceptional 32% net income growth seen by Aarti Pharmalabs over the past five years is pretty remarkable. Taking into consideration that the ROE is not particularly high, we reckon that there could also be other factors at play which could be influencing the company's growth. Such as - high earnings retention or an efficient management in place.

As a next step, we compared Aarti Pharmalabs' net income growth with the industry, and pleasingly, we found that the growth seen by the company is higher than the average industry growth of 13%.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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 Aarti Pharmalabs is trading on a high P/E or a low P/E, relative to its industry.

Is Aarti Pharmalabs Making Efficient Use Of Its Profits?

Aarti Pharmalabs has a really low three-year median payout ratio of 10%, meaning that it has the remaining 90% left over to reinvest into its business. This suggests that the management is reinvesting most of the profits to grow the business as evidenced by the growth seen by the company.

Along with seeing a growth in earnings, Aarti Pharmalabs only recently started paying dividends. Its quite possible that the company was looking to impress its shareholders.

Summary

Overall, we feel that Aarti Pharmalabs certainly does have some positive factors to consider. Despite its low rate of return, the fact that the company reinvests a very high portion of its profits into its business, no doubt contributed to its high earnings growth. While we won't completely dismiss the company, what we would do, is try to ascertain how risky the business is to make a more informed decision around the company. You can see the 1 risk we have identified for Aarti Pharmalabs by visiting our risks dashboard for free on our platform here.

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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.